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Insurer Woes Could Hit Banks

Potential downgrades to bond insurers could force banks to return bad mortgage paper to their books.

More pain may be in the offing for investment banks such as

Merrill Lynch


, 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) - Get Arcosa Inc. Report

, 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


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.

ACA, for one, guarantees some $60 billion of CDO securities. The problems with monoline insurers are not insignificant, because in total such firms guarantee trillions in debt securities.

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JPMorgan analyst Andrew Wessel also told


in a phone interview Wednesday that ACA may be the first monoline insurer to get downgraded. The downgrade worries have sent ACA shares to 82 cents, down by a whopping 25% in Wednesday's trading.

A call to ACA CEO Alan Roseman in New York was not immediately returned.

Fitch analyst Thomas Abruzzo told

that the rating agency, which does not cover ACA, has been closely tracking monoline companies as a group and has many of the firms on ratings watch for the next few weeks. Abruzzo said Fitch's rating moves, if any, on some of the names would allow the insurers to shore up their balance sheets, which could include the monolines obtaining reinsurance or obtaining external funds.

Also under the microscope are monoline insurance firms

Ambac Financial Group


and closely held insurance firm FGIC.

Firms such as Merrill and other big banks can ill afford to take more hits related to subprime securities.

Merrill saw the departure of CEO Stan O'Neal after the securities firm said it would face some $8.4 billion in writedowns on leveraged loans and asset-backed securities.

NYSE Euronext


chief John Thain will replace O'Neal on Dec. 1.



(C) - Get Citigroup Inc. Report

CEO Chuck Prince felt pressured to resign amid the announcement that the big bank would see writedowns as high as $11 billion.

A mess related to monoline insurers could further add stress to such firms and pale in comparison to their current worries, given that those insurers account for some $2.4 trillion to $2.6 trillion of municipal bonds and structured debt such as CDOs.

Josh Rosner, managing director at research firm Graham Fisher in New York told

the monoline problems could be a jagged pill to swallow for some of the major firms, because they act as counterparties, providing additional protection for investors in the form of derivative securities known as credit default swaps.

Credit default swap exposure for some of the big banks could be in the order of $200 billion to $300 billion, if monoline insurer downgrades become a reality, Rosner notes.

If that scenario plays out, the next hit could be Wall Street bonuses.