This WSJ article about ACA Capital Holding, shows financial firms adeptness in managing their balance sheet. ACA, ostensibly an insurance firm, was undercapitalized from the beginning. Based on the firm’s ‘A’ credit rating, the firm has a veneer of security which fell apart when S&P downgraded them to triple-C in December – a canary in the subprime coalmine. To avoid collapse, the firm is negotiating with the banks to avoid posting collateral.
Why would a bank go to such an undercapitalized firm for insurance? The WSJ gives this answer which sounds very much like SPE’s Enron used before its own collapse:
Investment banks paid ACA annual fees for bearing the risk in their debt securities. This shielded them from the impact of market-price fluctuations, so the banks didn’t have to reflect such fluctuations in their earnings reports.
As long as ACA kept its single-A rating, the banks didn’t require ACA to post collateral even if the securities it insured slipped in value. It’s different if a hedge fund, which doesn’t have a credit rating, is selling the insurance. In that case, each time the security insured falls in value, the hedge fund may be asked to put up more collateral.
Enron followers remember Special Purpose Entities as companies which were used to manage earning and to avoid reporting losses. They weren’t illegal. These related parties met the letter of the law, while violating the spirit and were instrumental in the collapse of the firm.
Essentially, they existed so Enron could avoid posting certain debts and showing less volatility. If the SPE’s had enough outside equity (3%) to be considered independent they did not have to be consolidated on Enron’s balance sheet. Enron crammed the SPE’s full of junk it didn’t want and couldn’t offload anywhere else.
ACA’s performed the same function. If everything is going up, the system works. ACA profits since they don’t have to make good on any policies, and the banks get to move junk (and its volatility) off their balance sheets. But when the market turned sour and all of the subprime securities moved down in unison, the equity was quickly used up and the firm collapsed. As Enron’s SPEs weren’t really independent, ACA was never really an insurance firm.
