Barron's: Subprime s Ultimate Time Bomb?
(From BARRON'S)
By Jonathan R. Laing
Despite a glossy roster of owners like bear Stearns Merchant Bank and New York investment company Third Avenue Trust, ACA Capital has flown under Wall Street's radar for most of its 10-year history.
And perhaps that has been a good thing, given ACA's rather picaresque history. The firm's founder, H. Russell Fraser, often arrived at the New York headquarters in full Marlboro Man western regalia-until he was sent packing to his ranch in Wyoming in 2001 as a result of lousy results in ACA's original business of insuring low-rated municipal-bond issues. Then in 2004, ACA suffered the indignity of having its stock's initial public offering aborted shortly before launch when its primary underwriter, JPMorgan, took a walk. It seems that, late in the process, Morgan became concerned about some personal-tax issues of Fraser's successor, who has since departed.
With new management in place, ACA was finally able to get its IPO off last fall. Yet investor disinterest forced the company to cut both the size and the projected offering price. ACA was able to raise just a paltry $79 million.
Yet ACA's days of relative anonymity are fast coming to an end. For in recent weeks, the insurer has been drawn into middle of the mushrooming subprime-mortgage crisis, by virtue of having quietly over the past two years insured $15.7 billion of predominantly subprime securities. And the bulk of these guarantees ($9.3 billion worth) have been placed on some of the most speculative paper in this free-wheeling market -- so-called mezzanine, subprime collateralized debt obligations, or CDOs.
In all, the firm's CDO exposure, including subprime and instruments backed by various corporate and commercial mortgage debt, totals an imposing $61 billion of value -- on a capital base, or shareholder net worth, of just $326 million. A leverage ratio, in other words, of over 180-to-1.
Not surprisingly, the stock (ticker: ACA) has been pounded in the last month and a half, falling from over 15 on June 19 to a low of 5.17 on July 24. It rallied to back over 7 last week, after management worked to calm market jitters over the company's liquidity and asset quality during the second-quarter analyst call. "ACA's stock has become the ultimate derivative for the subprime-mortgage market, allowing those with bearish views to pound it on the short side," says Standard & Poor's analyst Dick P. Smith, who recently reaffirmed his single-A rating on the company.
Various doomsday scenarios are revolving around ACA, which has a market value of about $260 million. Some critics depict the insurer as a giant warehouse in which various Wall Street securitizers such as Bear Stearns (BSC), which holds 27.7% of the company's stock, Merrill Lynch (MER), Lehman Brothers (LEH), Citigroup (C) and RBS Greenwich Capital have parked billions of dollars of risky obligations in order to obtain capital relief, avoid earnings volatility and gussy up their balance sheets. Bear Stearns, for its part, has said it has confidence in ACA's management.
Yet, should ACA buckle under this outsized burden, all $61 billion of the exposure it has insured would come cascading back on the balance sheets of the aforementioned firms and some 25 other Wall Street counterparties with which ACA deals. The possibility of hefty losses likewise looms, particularly in the subprime CDOs.
ACA management, both during last week's earnings call and a private discussion with Barron's, was quick to dismiss the possibility of the company having major problems. Including its shareholder net worth of $326 million, the company says it has claims-paying resources of more than $1 billion, which should be more than enough to satisfy any future liquidity needs.
Moreover, 99% of its $61 billion in CDO risk exposure is still rated not just triple-A but "super" senior triple-A, with ample collateral protection, even in the now-troubled subprime area, to endure any financial direct hit. Finally, as a long-term guarantor, ACA claims that it isn't subject to the same capital-depleting hits from mark-to-market reductions as many other players -- that is, as long as its CDO risks aren't downgraded or start actually generating claims losses.
Yet one wonders whether ACA is living in a Prague Spring, ignoring menaces that lie ahead. Subprime delinquencies and loan defaults are surging, of course, but not yet at a pace to trigger claims losses for ACA. But the crisis is still young. Over the next year and a half, monthly mortgage payments on some $600 billion of subprime mortgages will be rising sharply for already financially-strapped borrowers, as the loans reach the dreaded two-year reset date. Meantime, foreclosure losses for lenders figure to surge, as properties are dumped into an increasingly-glutted market.
Of particular concern are the $9.3 billion in mezzanine CDOs, mostly backed by subprime mortgages that ACA has insured. These are comprised of triple-B minus and some triple-B slices of different subprime-mortgage-backed securities that have been bundled together by dealers into CDOs that are then tiered in the exact same fashion as the underlying securities. Returns generated from mortgage interest and principal payments in the pools underlying the securities flow down the capital structure, slaking the thirst of the higher-rated slices or tranches first before trickling down to the lower levels. Thus any losses in the collateral pool are absorbed or felt first at the lower portions of the securitizations.
ACA makes much of the idea that as a guarantor of only super senior triple-A paper, it would seem to be well-protected. Claims losses in its mezzanine CDOs would have to immolate all the tranches below ACA's, or 40% of the CDO's capital structure, before ACA would lose a dime as insurer of only the top 60% of the structure.
But remember, the tranches comprising its mezzanine CDOs consist of only triple-B slices of the mortgage-backed securities pools, which are far less protected from loss. In fact, all it takes to completely snuff out the triple-B slices are cumulative losses in its underlying mortgage pool of just 7%. Hence, modest collateral impairment of 7% spread across the pools underlying the mezzanine CDOs would be enough to pancake the entire structure, from the lower-rated piece all the way to the rarified, top 60% super triple-A part of the CDO guaranteed by ACA. If this were to happen, ACA would be on the hook for virtually its entire $9.3 billion mezzanine risk exposure.
An unimaginable occurrence? Not really. The very S&P that last Friday claimed that problems in the subprime market constituted no threat to ACA's single-A rating shocked Wall Street last month by forecasting cumulative losses on 2006 vintage subprime mortgages of 11% to 14%. This is a jump from the loan-loss projection earlier made by Moody's of 6% to 8% impairments on 2006 loans backing different subprime securitizations. Of ACA's $9.3 billion in mezzanine guarantees, nearly half consist of this 2006 paper. And its remaining vintages, 2005 and 2007, are scarcely performing better either in their relatively short lives.
Equally unsettling has been the price action in the TABX-40-100 index, which reflects current expectations of the value of the kind of senior tranches of 2006 vintage CDOs that ACA has insured in abundance. The TABX is currently trading at around 43 cents on the dollar. This means that if ACA were to mark its $4.4 billion in 2006 CDO guarantees to this index, its GAAP net worth would fall from a positive $326 million to a negative $2 billion or so.
ACA officials insist that the TABX reflects current subprime-market fear and hysteria rather than any sober appraisal of true market fundamentals. Moreover, the company claims that the mortgage pools that the TABX references are far less diversified than those pools standing behind ACA's guarantees. Finally, the TABX reflects the frenzied hedging of subprime-market participants who are subject to the liquidity risk of having their credit lines pulled. ACA, as long as it maintains its A-rating, has no such risk.
There's some truth to these claims, but only some. GAAP accounting, but not insurance accounting, required ACA to make some mark-to-the-market adjustment to its CDO exposures, although the company has wide discretion on the measures it uses. Thus in the second quarter, ACA took a minimal after-tax charge of just $43.9 million, which is a far cry from the $2.4 billion adjustment that the TABX is indicating just on the firm's subprime CDO book of 2006 paper.
But the mezzanine exposure isn't the only peril in ACA's $15.7 billion subprime-guaranty portfolio. The company has also insured some $5 billion of so-called "high grade" subprime CDOs. Single-A tranches of underlying mortgage pools comprise about two-thirds of these instruments. And although the single-A tranches are situated somewhat higher in the mortgage-backed securities' pecking order than the mezzanine triple-B slices, they aren't all that protected from big hits. Collateral losses of 10% on the underlying pools completely wipe out these tranches and two-thirds of any high-grade CDO of which they are part. Given ACA's exposure in its high grade CDO guaranty portfolio, it could suffer losses there of nearly $3 billion on its $5 billion of exposure.
Finally, ACA has insured a $444 million "CDO-squared," or a CDO comprised of other CDO tranches and thus separated from underlying mortgage-backed securities twice over. So any collateral losses in the pools of underlying mortgage-backeds hit CDO-squareds harder and more quickly than their CDO sires. A 4.5% loss in the underlying collateral is enough to snuff most CDO-squareds.
Ultimately, ACA's fate will be decided in the court of market opinion -- by the performance of literally thousands of subprime mortgages embedded in various mortgage-backed pools. The S&P prediction of low-teen collateral losses is probably as good as any. But it all depends upon how these losses are distributed. If the average consists of a minority of pools with huge losses and most get minimal hits, ACA could live to fight another day. Yet should U.S. subprime woes prove to be systemic across different geographies, then ACA could be toast. We should know the answer within the next year.
For Barron's subscription information call 1-888-BARRONS ext. 685 or inquire online at http://www.barronsmag.com/subscription/subscription.html.
(From BARRON'S)
By Jonathan R. Laing
Despite a glossy roster of owners like bear Stearns Merchant Bank and New York investment company Third Avenue Trust, ACA Capital has flown under Wall Street's radar for most of its 10-year history.
And perhaps that has been a good thing, given ACA's rather picaresque history. The firm's founder, H. Russell Fraser, often arrived at the New York headquarters in full Marlboro Man western regalia-until he was sent packing to his ranch in Wyoming in 2001 as a result of lousy results in ACA's original business of insuring low-rated municipal-bond issues. Then in 2004, ACA suffered the indignity of having its stock's initial public offering aborted shortly before launch when its primary underwriter, JPMorgan, took a walk. It seems that, late in the process, Morgan became concerned about some personal-tax issues of Fraser's successor, who has since departed.
With new management in place, ACA was finally able to get its IPO off last fall. Yet investor disinterest forced the company to cut both the size and the projected offering price. ACA was able to raise just a paltry $79 million.
Yet ACA's days of relative anonymity are fast coming to an end. For in recent weeks, the insurer has been drawn into middle of the mushrooming subprime-mortgage crisis, by virtue of having quietly over the past two years insured $15.7 billion of predominantly subprime securities. And the bulk of these guarantees ($9.3 billion worth) have been placed on some of the most speculative paper in this free-wheeling market -- so-called mezzanine, subprime collateralized debt obligations, or CDOs.
In all, the firm's CDO exposure, including subprime and instruments backed by various corporate and commercial mortgage debt, totals an imposing $61 billion of value -- on a capital base, or shareholder net worth, of just $326 million. A leverage ratio, in other words, of over 180-to-1.
Not surprisingly, the stock (ticker: ACA) has been pounded in the last month and a half, falling from over 15 on June 19 to a low of 5.17 on July 24. It rallied to back over 7 last week, after management worked to calm market jitters over the company's liquidity and asset quality during the second-quarter analyst call. "ACA's stock has become the ultimate derivative for the subprime-mortgage market, allowing those with bearish views to pound it on the short side," says Standard & Poor's analyst Dick P. Smith, who recently reaffirmed his single-A rating on the company.
Various doomsday scenarios are revolving around ACA, which has a market value of about $260 million. Some critics depict the insurer as a giant warehouse in which various Wall Street securitizers such as Bear Stearns (BSC), which holds 27.7% of the company's stock, Merrill Lynch (MER), Lehman Brothers (LEH), Citigroup (C) and RBS Greenwich Capital have parked billions of dollars of risky obligations in order to obtain capital relief, avoid earnings volatility and gussy up their balance sheets. Bear Stearns, for its part, has said it has confidence in ACA's management.
Yet, should ACA buckle under this outsized burden, all $61 billion of the exposure it has insured would come cascading back on the balance sheets of the aforementioned firms and some 25 other Wall Street counterparties with which ACA deals. The possibility of hefty losses likewise looms, particularly in the subprime CDOs.
ACA management, both during last week's earnings call and a private discussion with Barron's, was quick to dismiss the possibility of the company having major problems. Including its shareholder net worth of $326 million, the company says it has claims-paying resources of more than $1 billion, which should be more than enough to satisfy any future liquidity needs.
Moreover, 99% of its $61 billion in CDO risk exposure is still rated not just triple-A but "super" senior triple-A, with ample collateral protection, even in the now-troubled subprime area, to endure any financial direct hit. Finally, as a long-term guarantor, ACA claims that it isn't subject to the same capital-depleting hits from mark-to-market reductions as many other players -- that is, as long as its CDO risks aren't downgraded or start actually generating claims losses.
Yet one wonders whether ACA is living in a Prague Spring, ignoring menaces that lie ahead. Subprime delinquencies and loan defaults are surging, of course, but not yet at a pace to trigger claims losses for ACA. But the crisis is still young. Over the next year and a half, monthly mortgage payments on some $600 billion of subprime mortgages will be rising sharply for already financially-strapped borrowers, as the loans reach the dreaded two-year reset date. Meantime, foreclosure losses for lenders figure to surge, as properties are dumped into an increasingly-glutted market.
Of particular concern are the $9.3 billion in mezzanine CDOs, mostly backed by subprime mortgages that ACA has insured. These are comprised of triple-B minus and some triple-B slices of different subprime-mortgage-backed securities that have been bundled together by dealers into CDOs that are then tiered in the exact same fashion as the underlying securities. Returns generated from mortgage interest and principal payments in the pools underlying the securities flow down the capital structure, slaking the thirst of the higher-rated slices or tranches first before trickling down to the lower levels. Thus any losses in the collateral pool are absorbed or felt first at the lower portions of the securitizations.
ACA makes much of the idea that as a guarantor of only super senior triple-A paper, it would seem to be well-protected. Claims losses in its mezzanine CDOs would have to immolate all the tranches below ACA's, or 40% of the CDO's capital structure, before ACA would lose a dime as insurer of only the top 60% of the structure.
But remember, the tranches comprising its mezzanine CDOs consist of only triple-B slices of the mortgage-backed securities pools, which are far less protected from loss. In fact, all it takes to completely snuff out the triple-B slices are cumulative losses in its underlying mortgage pool of just 7%. Hence, modest collateral impairment of 7% spread across the pools underlying the mezzanine CDOs would be enough to pancake the entire structure, from the lower-rated piece all the way to the rarified, top 60% super triple-A part of the CDO guaranteed by ACA. If this were to happen, ACA would be on the hook for virtually its entire $9.3 billion mezzanine risk exposure.
An unimaginable occurrence? Not really. The very S&P that last Friday claimed that problems in the subprime market constituted no threat to ACA's single-A rating shocked Wall Street last month by forecasting cumulative losses on 2006 vintage subprime mortgages of 11% to 14%. This is a jump from the loan-loss projection earlier made by Moody's of 6% to 8% impairments on 2006 loans backing different subprime securitizations. Of ACA's $9.3 billion in mezzanine guarantees, nearly half consist of this 2006 paper. And its remaining vintages, 2005 and 2007, are scarcely performing better either in their relatively short lives.
Equally unsettling has been the price action in the TABX-40-100 index, which reflects current expectations of the value of the kind of senior tranches of 2006 vintage CDOs that ACA has insured in abundance. The TABX is currently trading at around 43 cents on the dollar. This means that if ACA were to mark its $4.4 billion in 2006 CDO guarantees to this index, its GAAP net worth would fall from a positive $326 million to a negative $2 billion or so.
ACA officials insist that the TABX reflects current subprime-market fear and hysteria rather than any sober appraisal of true market fundamentals. Moreover, the company claims that the mortgage pools that the TABX references are far less diversified than those pools standing behind ACA's guarantees. Finally, the TABX reflects the frenzied hedging of subprime-market participants who are subject to the liquidity risk of having their credit lines pulled. ACA, as long as it maintains its A-rating, has no such risk.
There's some truth to these claims, but only some. GAAP accounting, but not insurance accounting, required ACA to make some mark-to-the-market adjustment to its CDO exposures, although the company has wide discretion on the measures it uses. Thus in the second quarter, ACA took a minimal after-tax charge of just $43.9 million, which is a far cry from the $2.4 billion adjustment that the TABX is indicating just on the firm's subprime CDO book of 2006 paper.
But the mezzanine exposure isn't the only peril in ACA's $15.7 billion subprime-guaranty portfolio. The company has also insured some $5 billion of so-called "high grade" subprime CDOs. Single-A tranches of underlying mortgage pools comprise about two-thirds of these instruments. And although the single-A tranches are situated somewhat higher in the mortgage-backed securities' pecking order than the mezzanine triple-B slices, they aren't all that protected from big hits. Collateral losses of 10% on the underlying pools completely wipe out these tranches and two-thirds of any high-grade CDO of which they are part. Given ACA's exposure in its high grade CDO guaranty portfolio, it could suffer losses there of nearly $3 billion on its $5 billion of exposure.
Finally, ACA has insured a $444 million "CDO-squared," or a CDO comprised of other CDO tranches and thus separated from underlying mortgage-backed securities twice over. So any collateral losses in the pools of underlying mortgage-backeds hit CDO-squareds harder and more quickly than their CDO sires. A 4.5% loss in the underlying collateral is enough to snuff most CDO-squareds.
Ultimately, ACA's fate will be decided in the court of market opinion -- by the performance of literally thousands of subprime mortgages embedded in various mortgage-backed pools. The S&P prediction of low-teen collateral losses is probably as good as any. But it all depends upon how these losses are distributed. If the average consists of a minority of pools with huge losses and most get minimal hits, ACA could live to fight another day. Yet should U.S. subprime woes prove to be systemic across different geographies, then ACA could be toast. We should know the answer within the next year.
For Barron's subscription information call 1-888-BARRONS ext. 685 or inquire online at http://www.barronsmag.com/subscription/subscription.html.
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