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The Restructuring of ACA: Model or Cautionary Tale?
HRF Associates professionals discuss positive and negative aspects of transaction.
October 6, 2008
With the Aug. 7 announcement by the Maryland Insurance Administration regarding the restructuring of ACA Financial Guaranty, there are questions in the market about how it was designed, how it will work, and whether or not it should serve as an example for future restructurings.
Our comments are based on our experience and knowledge of the financial guaranty and rating industries gathered during the last 35 years. What follows are our general observations, based on the information released to the public.
On a positive note, the agreement appears to convert approximately $69 billion of structured finance notional par exposure into an aggregate of $1 billion of surplus notes, which will be distributed to the former counterparties in ACA's structured policies. These counterparties also become the owner of ACA Financial Guaranty.
The surplus notes carry no interest and are subordinate to the claims of policyholders, claimant and beneficiary claims, and to all other classes of creditors other than the surplus note holders. Surplus note holders will then share pro rata in the distribution of ACA's assets during the runoff period.
Another aspect of the transaction is that the company is required to maintain its certificates of authority and minimum capital and surplus as needed to conduct insurance business in Maryland and all other states and territories of the US.
Maryland currently has the lowest capital requirement for operating a financial guaranty company, $15 million, with California the highest at $75 million. By maintaining its good standing in all states, ACA enhances its value in possible future transactions in the event of a sale of its shell or remaining municipal book of business.
However, there are a number of aspects of this transaction that raise some concerns, including the degree of reliance placed by the Maryland Insurance Administration on a financial model created by ACA Financial's management.
Also at issue are the permission granted by Maryland to ACA Financial's former parent to transfer more than $47 million in cash and other valuable assets from ACA to its parent, the apparent lack of input from any of ACA Financial's municipal stakeholders, and the absence of any meaningful disclosures by the parties in the transaction.
Given the troubling climate in the financial guaranty industry over in the last year, it is refreshing to see that any of these companies has been able to resolve claims arising from the subprime mortgage debacle. While the publicly-available information clearly reveals some positive aspects of the ACA transaction, many unanswered issues remain to keep ACA Financial's policyholders, bond issuers, or other stakeholders up at night.
The Model
In approving this transaction, the Maryland Insurance Administration relied on a financial model prepared by the management of ACA Financial. The model was intended to determine whether or not ACA Financial would have what the order called sufficient "assets and operational capacities" to successfully run off its business.
It should be noted that by necessity, this financial model seeks to project operational returns for the next 37 years, through 2045, the date when the final exposure on ACA's municipal book of business is set to expire. In the order, the administration goes on to state that in reviewing the model, it relied upon "conservative assumptions" and the advice of "specialists in modeling anticipated losses on insurance written on municipal obligations," among other specialties.
The rating agencies have each developed comprehensive and well documented models of municipal bond performance that they use to determine the credit quality of financial guaranty companies. Some argue that these models assume unrealistically high levels of expected defaults, leading to a requirement to maintain overly-conservative balance sheets. Others note that none of these models accurately predicted the meltdown in the subprime market. However, these models are important because they have resulted in consistent treatment among all of the financial guaranty companies.
Even if ACA Financial could demonstrate that they should be allowed to model their portfolio and operations differently than the rating agencies do, using the rating agency models would provide the municipal stakeholders an important benchmark for evaluating the runoff company's capacity to pay claims.
The negotiations that led to the Maryland's decisions on the model are not transparent. The market may well come to demand complete transparency with regard to this model and its key assumptions. ACA Financial also has agreed to report to the Maryland Insurance Administration on a semiannual basis the actual results of the runoff company compared to the results assumed and projected in the financial model. Because a company in runoff has far less of a claim to trade secrets than does a going concern, stakeholders who have been unrepresented in this process should seek that these reports be made public immediately upon receipt by the Maryland Insurance Administration.
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