Lawsuits add to ACA Capital's downgrade misery

Two suits have been filed separately at the US District Court for the Southern District of New York by firms Coughlin Stoia Geller Rudman & Robbins and Abraham Fruchter & Twersky on behalf of “all persons who purchased the common stock of ACA Capital” at the time of its initial public offering on November 10, 2006.

Both actions allege ACA Capital failed to disclose that the company’s collateralised debt obligation (CDO) assets held by its ACA Financial Guaranty arm “were materially impaired and overvalued”, and violated the US Securities Act of 1933.

The lawsuits follow Standard & Poor’s (S&P) announcement on November 9 that ACA Financial Guaranty, the subsidiary of ACA Capital that insures investment banks' CDO and mortgage-backed security debt, was being placed on “credit watch” after a dismal third quarter in which the company suffered $1.7 billion in writedowns, largely due to significant subprime mortgage exposures in its CDO portfolio.

Stressing the gravity of its concerns, S&P noted its anxiety is being exacerbated by the fact that "the significant slowing of the subprime mortgage market directly affects two of ACA's three product lines, possibly necessitating significant changes to the company's business model”.

Should S&P lower ACA Financial’s current A rating, the insurer would be contractually obliged to post a $1.7 billion margin and could face insolvency. In its third-quarter filing to the SEC, ACA Financial stated it insures $69 billion in asset-backed and corporate bonds through the use of credit default swaps, including $25 billion of subprime mortgage-backed securities.

Even if the insurer raises enough capital in the next quarter to avoid being downgraded, the possibility remains that payouts on insured bonds could wipe out any gains, making the company's liquidation all but inevitable. Shares in ACA Capital have plummeted throughout the second half of 2007, falling from $14.84 in July to just $0.90 by late November.