S&P slashes its rating of bond insurer

NEW YORK - A major insurer of bonds was downgraded to "junk" status yesterday, a move that could cost banks and local governments billions of dollars.

Credit-rating agency Standard & Poor's slashed its credit rating for bond insurer ACA Financial Guaranty Corp. to a noninvestment-grade "CCC" from investment-grade "A." S&P said ACA's capital cushion of $650 million was still $2.2 billion short of what it needed to cover potential losses.

In downgrading ACA and placing warnings on four other insurers, S&P cited concerns about increasing claims from defaults on mortgage-backed bonds and the risk that those claims could drain the bond insurers of needed capital. The agency also acknowledged that its actions could change the way bond insurers do business.

The downgrade led S&P to cut ratings on bonds issued to fund entities ranging from schools to sewer districts to prisons to parks. The move makes it unlikely that ACA could insure any more bonds, and could spark a municipal-borrowing crisis, according to Peter Schiff, chief executive officer of Euro Pacific Capital.

"Many municipalities get high credit ratings because their bonds are insured," Schiff said. "Higher borrowing costs for cities will force them to charge higher property taxes, which will increase the strain on consumers. And some cities may be shut out of the credit markets."

The new strain on civic funding comes as a weak housing market threatens to drain local coffers of property taxes. Many cities have been banking on higher property taxes, but now homes are being valued lower, and that also reduces funds available to the cities, he said.

Jeff Doss, executive director of the Northeast Public Sewer District in the St. Louis suburb of Fenton, Mo., said he did not foresee any effect from the ACA downgrade. His agency recently refinanced its $15 million in bonds, but he said some people were still at risk.

"It's the people whose bonds are aged enough that the holders can call them back in that could be in for a world of hurt," Doss said. Some bonds carry provisions that let their holders demand immediate repayment after a period if some conditions are met.

Rebecca Floyd, general counsel for the Kansas Development Finance Authority, said she did not expect problems after a $4.3 million health-care-facility bond her agency worked on was downgraded to junk.

"It's hard to project at this point," Floyd said. "We know the problems are out there, and we're vetting the insurers ourselves. Where I see people getting pinched is the smaller borrowers who look to raise their credit rating."

In cases where the municipality provided its rating as the backstop for a bond insured by ACA, S&P cut the bond's ratings to match those of the municipality. Ratings for bonds ACA insured, but that were not backed by a municipality's underlying rating, fell to "CCC" to match ACA's rating.

Bonds cut to "CCC" because there is no other underlying rating can be resubmitted for review, S&P said. In that case, a municipality could have the bond upgraded to match its credit rating.

Downgrades of bond insurers can also lead to losses at the companies that use them. Only minutes after S&P's downgrade of ACA, CIBC World Markets Inc. said insurance for $3.5 billion in securities it held backed by subprime mortgages might no longer be viable.

The S&P action on ACA comes amid reports that investment banks, including Merrill Lynch & Co. Inc. and the Bear Stearns Cos. Inc., were in talks to bail out the struggling bond insurer. ACA and Merrill Lynch were not immediately available to comment.

Bear Stearns declined to comment on any bailout speculation, although a spokesman said the investment bank was a small creditor of ACA and thus had little exposure to the bond insurer.

As part of a mass review of the bond insurers, S&P also placed Financial Guaranty Insurance Co. on negative credit watch. FGIC currently carries a "AAA" rating. A negative watch means there is one chance in two that the rating could be downgraded in the next three months.

Ambac Financial Group Inc., MBIA Insurance Corp. and XL Capital Assurance Inc. - all larger than ACA and rated higher - were placed on a negative outlook by S&P, although their ratings were not changed. A negative outlook means there is a one chance in three that ratings will be cut in the next two years.