Insurer Woes Could Hit Banks

More pain may be in the offing for investment banks such as Merrill Lynch(MER), who hold hard-to-value mortgage paper.

Merrill may be forced to write down as much as $3 billion in so-called collateralized debt obligations, or CDOs, which have seen their values fall fast and hard because of securities tied to bad mortgage debt, according to Lehman Brothers analyst Roger Freeman.

A Merrill spokeswoman declined to comment. But at the heart of the problem is an anticipated downgrade of monoline bond insurer ACA Capital Holdings(ACA), which could set off a chain of downgrades culminating in big banks being forced to put bad mortgage paper back on their books.

ACA -- of which writedown-hammered Bears Stearns(BSC) holds a significant stake -- and other insurers provide insurance on debt securities for municipalities and CDOs that enhance the debt's credit rating. That credit enhancement makes the debt suitable for investment by many institutional investors, including pensions and endowments. But monolines have been under extreme duress over the past several weeks, due to increasing defaults.

As a result, monoline insurers face downgrades by rating agencies, including Moody's Investors Service and Fitch Ratings.

If companies such as ACA are downgraded, the securities they insure may be forced to post collateral against the insured debt or raise capital to shore up their balance sheets -- a move that could result in banks taking back debt on their books.