In a move that could signal trouble for the municipal bond market, troubled bond insurer ACA Capital Holdings Inc. has agreed to cede some control of its bond insurance operations to Maryland Insurance Regulators. In exchange, the regulators have given ACA a thirty-day waiver from posting additional capital, which it was required to do after Standard & Poors cut its credit rating on December 19, 2007.

ACA provided details about the agreement in a filing with the Securities and Exchange Commission on December 26, 2007 (the "SEC Filing"), a copy of which is attached here. In the SEC Filing, ACA explains that its subsidiary, ACA Financial Guaranty Corporation ("ACA FG") acts as a bond insurer with respect to various bonds, including mortgage backed securities. According to ACA, the credit risk it assumes by providing that bond insurance is then secured by contingent collateral arrangements. Under those agreements, if ACA's credit rating falls below a certain level, it is required to post additional collateral, which is what happened when Standard & Poors cut its credit rating.

ACA then explained that prior to - and in anticipation of - its downgrade, ACA FG entered into an agreement and consent order with the Insurance Commissioner for the State of Maryland. Under the agreement, ACA FG agreed to provide the Maryland Insurance Administration (the "MIA") with reports and information. More importantly, it ceded significant control to the Insurance Commissioner by agreeing "not to engage in certain activities without providing prior notice and opportunity to object to the MIA including, without limitation, pledging or assigning any assets, paying dividends or engaging in certain material transactions." The agreement also required that ACA FG enter into a forbearance agreement with the insured counterparties, which it did.

These concessions reflect the grave consequences of the downgrade by Standard & Poors and could signal significant problems for the municipal bond market. According to press reports, ACA traditionally acted as a municipal bond insurer. Only recently did it begin insuring mortgage backed securities risks. Traditional municipal bond insurers provide insurance that gives the municipal bonds ratings high enough to qualify as "investment grade." Most institutional holders are subject to investment guidelines that only allow them to purchase and hold "investment grade" securities. Without this insurance, therefore, the credit rating agencies often cannot given the municipal bonds a rating high enough for them to qualify as investment grade securities.

Municipal bond insurers like ACA, however, have in recent years expanded the scope of their operations by writing insurance on mortgage backed securities. As a result of the rising delinquency rate on the underlying subprime mortgages, it now looks like the insurers will have to make payments as a result of defaults on bonds which have these mortgages as collateral. The increasing likelihood of these insurance payments in the case of ACA caused Standard & Poors to downgrade its credit rating, which is what caused it to enter into the agreement with the Insurance Commissioner. So far, ACA is the only bond insurer to be downgraded. However, others may soon follow, with Fitch Ratings saying it might cut ratings on both MBIA Inc. and Ambac Financial Group Inc. if they cannot raise new capital soon.

These potential downgrades could lead to downgrades of the credit ratings on the municipal bonds theses insurers have insured below their original investment grade. If that happens, the institutional holders of the municipal bonds may be forced to sell them because they violate their investment guidelines. That type of sell-off could lead to a collapse of the municipal bond market that would be strikingly similar to the collapse of the mortgage backed securities market this past summer.