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Is this story getting the credit it deserves?

ACA may not be the largest bond insurer in the world, but its dramatic downgrade by Standard & Poor’s late on Wednesday (from A to CCC) is going to have a serious impact.

Take, as illustration, the fact that ACA’s downgrade also led to the immediate downgrade of 3024 municipal bond issues on Wednesday. Debt of schools, hospitals and such like.

A downgrade of its own institutional rating - as has happened - requires ACA to post collateral. In the event, ACA now needs to stump up $1.7bn cash. Problematic, considering the insurer lost a small fortune this year and has a share price so sinfully low it makes Northern Rock look like Madonna with Child.

ACA has been granted a stay on posting that collateral - it has until January 18th to find it. If it doesn’t by then, it will be insolvent. And if it becomes insolvent, of course, all those swaps on bonds will be rendered worthless. Thus the action by S&P on those muni bonds.

That’s not even the really bad bit. The worrying fact is what ACA’s downgrade means for the CDO market. ACA started out as a vanilla muni bond guarantor. But then it got heavily involved in the lucrative CDO business - earning itself a reputation as a leading guarantor, and even sponsor, of the deals. (Indeed, ACA actually runs 26 CDOs. Details on those are available in ACA’s voluminous 10-Q.)

If ACA is unable to post its required collateral in a month’s time, the firm’s special new year’s gift for Wall Street’s finest will be an additional $69bn in CDO exposure.ACA is knee deep in super-senior tranches of CDOs - just as many of the banks are. Confusion arises here when super-senior exposure - be it with a bank or a monoline - is referred to as a tranche, because it isn’t really. Super seniors are just big credit default swaps, not bonds like normal CDO debt. So you could, by another name, call super-senior tranches “insurance.” Indeed, holding super-senior tranches (or more correctly, being the counterparty to a CDO in a super-senior swap) is the previously lucrative CDO insurance business that ACA became so adept at.

Why does this mean banks will end up taking on the $69bn super-seniors?

Because if ACA terminates those super-senior swaps, the synthetic CDOs which use them would implode. So the banks which run the CDOs know they will have to take on the super-senior swaps instead.

Banks, of course, are familiar with super senior arrangements. Most of their CDO writedowns so far have been based on super senior swaps they’re already counterparties too. Indeed, in recent years, banks have been taking on super-senior swaps more and more - seeking to take a slice of the bond insurer’s pie. (Banks got interested when they realised they could take those low-yielding super senior coupons and sex them up by lumping them in a special conduit and applying leverage.)

As for which banks will be taking the ACA super-seniors on board, the two big names floating around are Merrill Lynch and Bear Stearns. Canadian bank CIBC has already ‘fessed up and said it expects to take $2bn extra exposure from ACA - if, of course, no-one bails the insurer out before January 18.