So, ACA Financial insures USD69bn in asset-based/corporate bonds. ~25bn of that is "bundles" of AAA rated subprime mortgages. That would be houses which are held by people about to pay a Whole Lot More every month, though they seem safe (hence the AAA rating). Of course, the rating system they used was utterly flawed (it is called mark-to-model), relied on rash estimates, and is based on an econ. theory which has not proven to be… umm… let's say: predictive."

Why is this concerning?

Some background first:

Their insurance is basically a "if these bundles of mortgages (or Collateralized Debt Obligations) prove worthless, we will front the money for them." This insurance allows large investment banks (like the kind that entire cities/states place their investments in) to buy Collateralized Debt Obligations (CDO's) without worrying too much about how none of the component mortgages were examined or that there is not an active enough market to determine a true value to the CDOs. This happens when you move large amounts of stuff only a couple of times.
Since there is no market, a third party comes in and estimates the rating of the bundle of mortgages (CDO). And it looks like they did that estimation in a shoddy way. This estimation/selling is called "mark-to-market", and it is insurance by these v. large insurers that allow traders to sleep easy after buying a lot of something they do not know the true value of for a number that is ridiculously large.

So, they insure $25bn, Merrill Lynch (which is tanking) insures ~$14 bn, and Citigroup (which could not find a CEO, and may be breaking up) about $43bn… yes, these numbers are nutty.

Because they insure more than just AAA loans (they go down to A), they issue their contracts with a deal saying: "If Standard and Poor downgrades our credit rating, we will post a cash equiv. to our
mark-to-market number."
Since they insure so much, such a downgrade would make ACA insolvent.

the NYSE just delisted ACA Capital

So this kinda thing frightens investors bad…
Like Ambac reinsuring $29 bn of their portfolio.
Like Citigroup having to buy back $49bn worth of mortgages from their SIVs (more on these later)
And Freddie Mac losing $2bn last quarter, and ~$11bn this quarter.

And here is where it starts being a concern

This is why the government interventions (opening generous loan windows) have not been—and are not going to be—effective. This is not an irrational panic that just needs some money to show up for people to feel safe with, invest, and pay back later; this is a rational panic. As long as people mistrust the value of the CDOs which have been tossed around for the last decade (a healthy mistrust), no rational person will insure them. The lack of a known value and no safety net means no buyers. This means the investors who hold the mortgages cannot sell them until the true value has been determined. And the whole time, the jump in payment (reset) that characterizes the popular Adjustable Rate Mortgage (ARM) is causing people to default and face foreclosure. This eats away at the practical reason for holding the mortgages in the first place (banks/investors don't want property; they want people paying for their properties who risk losing them when they are late on a payment. So the investors (retirement groups/cities/Florida/banks) have no ability to sell something which gives them no money. That is not illiquidity, but insolvency. And of course, this means that there are less people with money to give out mortgages, which means a general slump (nose dive) in house building/trade/business…

Oh, and the interest rates cannot go down. The fed's cuts in their rates (which make bank's rates go down and make the market manically happy for a day or two) are pushing us into inflation. The fed cannot do this too many times before food gets too pricey.

Major banks want to buy up a whole bunch of AAA rated CDOs. They would do this through a Structured Investment Vehicle (SIV). SIVs are things that take out large long-term loans, and give out smaller, shorter-term loans. The SIV's are the term for the collection of investors who are buying the CDOs. It is also the handy vehicle for banks to get around regulations prohibiting them from doing stupid s***—like borrowing a lot, then hoping other people pay you back on their loans you gave them with your borrowed money (normally banks have to be able to front a certain percentage of their money transfer with assets they hold). The proposed "super-SIV" would hold some high rated CDOs.

How will this fare? Well, it will make the rest of the CDOs real worthless real quick (fun!), and hopefully make the chosen CDOs "golden" again. Investor confidence restored! Of course, IMO, this is smearing a lot of lipstick on a very ugly pig. These CDOs were valued capriciously, and every time someone glances at their true worth—like examining the default rates in the CDO—they drop in value. This is called a "write-down". Merrill Lynch lost about a third of the value in their AAA CDOs when they tested their worth. So when someone wants to offload their CDOs to this super-SIV, they subject their batch to inquiry. If it fares poorly, the thing is worse than garbage. If it passes muster, it did so not by a careful analysis of the mortgage holders/local property values/local industry, but by the fact that not too many people have defaulted in that CDO yet.

So the "super-SIV"… yeah….

Oh, and that Citigroup loss of $49bn I spoke of earlier, it is a good model for what the rest of the banks are facing… their SIV was a way to keep their massive risk (and losses) off the books. All they had to show was that they gave money to this entity, and they were getting some back. Now, in order to stabilize/guarantee the CDOs they hold, Citi is consolidating them with the rest of the company's finances. This means that the other investments of the bank lose their attraction, as Citi may have to sell them or use profits to shore up the CDOs formally hidden in their SIV. This was really shady accounting… celebrated by the free market.

So because of this, I was not surprised to read that bankrupt New Century Financial(another CDO dealer) says that its debtors have submitted $32bn in claims, leaving nothing for the shareholders. They have 55m outstanding shares, which peaked in 2004 at ~$65/share. They are at around 1.7 cents/share now.

And remember, banks were not the only kids playing with SIV's. "Stockholders" means a lot of people who do not know that their money was in this game.
And "massive default rates" means…

Well, the US Congress's Joint Econ. Committee estimates 2m families will lose their homes over the next 2 years. I think that is some BS; the first 8 months of 2007 saw 1.7m foreclosures, and after the $800bn in resetting Subprime ARM's (most ARMs were not subprime, btw), there is another burst.. of even nastier "Option ARM"s..
Reset Rates over the next 2 years

(a difficult graph… each bar is a month, starting in Jan 2007)