More Bailout's?

The New York Times printed an interesting article yesterday about the possibility of some major banks bailing out troubled bond Insurer ACA Capital Holdings. From the NYT:

Banks Study Bailing Out Struggling Bond Insurer

Officials from Merrill Lynch, Bear Stearns and other major banks are in talks to bail out a struggling bond insurance company that has guaranteed $26 billion in mortgage securities, according to two people briefed on the situation, because the insurer’s woes could force the banks to take on billions in losses they had insured against.

The insurer, ACA Capital Holdings, which lost $1 billion in the most recent quarter, has been warned by Standard & Poor’s that its financial guarantor subsidiary may soon lose its crucial A rating. If it did, the banks that insured securities with the ACA Financial Guaranty Corporation would have to take back billions in losses from the insurer under the terms of the credit protection they bought from the company.

News Flash, ACA Financial Guaranty Corp was cut to junk by S&P today, from Rueters:

S&P cuts ACA to "CCC" junk, acts on 6 bond insurers

NEW YORK, Dec 19 (Reuters) - Standard & Poor's cut its ratings on ACA Financial Guaranty Corp to junk as part of actions on six bond insurers on Wednesday.

S&P cut ACA's rating to "CCC," or eight levels below investment grade, from "A," the sixth-highest investment-grade rating. It also said it may cut Financial Guaranty Insurance Co's 'AAA' rating.

Well this is not good news considering the balance sheets of Merrill and Bear are already stretched.

The troubles at ACA could also serve as the first real test for credit default swaps, the tradable insurance contracts used by investors to protect, or hedge, against default on bonds. In June, the value of bonds underlying credit default swaps rose to $42.6 trillion, up from just $6.4 trillion at the end of 2004, according to the Bank for International Settlements.

“The hedge is only as good as the counterparty, or the other party, to the hedge,” said Joseph R. Mason, a finance professor at Drexel University and the Wharton School of the University of Pennsylvania. “This is part and parcel of the financial innovation that has grown very rapidly in recent years.”

....Banks that insured securities with ACA have another reason to keep the company afloat — if it fails they may have to restate earnings they have already booked as a result of their dealings with the company.

That doesn't sound good, the last thing Merrill needs after billions in writedowns is to restate earnings. What's the bet Merrill will be lining up to get equity injections just like Morgan Stanley's hugely dilutionary injection from China Investment Corp. announced today.