With the Aug. 7 announcement by the Maryland Insurance Administration regarding the restructuring of ACA Financial Guaranty, there are questions in the market about how it was designed, how it will work, and whether or not it should serve as an example for future restructurings.

Our comments are based on our experience and knowledge of the financial guaranty and rating industries gathered during the last 35 years. What follows are our general observations, based on the information released to the public.

On a positive note, the agreement appears to convert approximately $69 billion of structured finance notional par exposure into an aggregate of $1 billion of surplus notes, which will be distributed to the former counterparties in ACA's structured policies. These counterparties also become the owner of ACA Financial Guaranty.

The surplus notes carry no interest and are subordinate to the claims of policyholders, claimant and beneficiary claims, and to all other classes of creditors other than the surplus note holders. Surplus note holders will then share pro rata in the distribution of ACA's assets during the runoff period.

Another aspect of the transaction is that the company is required to maintain its certificates of authority and minimum capital and surplus as needed to conduct insurance business in Maryland and all other states and territories of the United States.

Maryland currently has the lowest capital requirement for operating a financial guaranty company, $15 million, with California the highest at $75 million. By maintaining its good standing in all states, ACA enhances its value in possible future transactions in the event of a sale of its shell or remaining municipal book of business.

However, there are a number of aspects of this transaction that raise some concerns, including the degree of reliance placed by the Maryland Insurance Administration on a financial model created by ACA Financial's management.

Also at issue are the permission granted by Maryland to ACA Financial's former parent to transfer more than $47 million in cash and other valuable assets from ACA to its parent, the apparent lack of input from any of ACA Financial's municipal stakeholders, and the absence of any meaningful disclosures by the parties in the transaction.

Given the troubling climate in the financial guaranty industry over in the last year, it is refreshing to see that any of these companies has been able to resolve claims arising from the subprime mortgage debacle. While the publicly available information clearly reveals some positive aspects of the ACA transaction, many unanswered issues remain to keep ACA Financial's policyholders, bond issuers, or other stakeholders up at night.

THE MODELIn approving this transaction, the Maryland Insurance Administration relied on a financial model prepared by the management of ACA Financial. The model was intended to determine whether or not ACA Financial would have what the order called sufficient "assets and operational capacities" to successfully run off its business.

It should be noted that by necessity, this financial model seeks to project operational returns for the next 37 years, through 2045, the date when the final exposure on ACA's municipal book of business is set to expire. In the order, the administration goes on to state that in reviewing the model, it relied upon "conservative assumptions" and the advice of "specialists in modeling anticipated losses on insurance written on municipal obligations," among other specialties.

The rating agencies have each developed comprehensive and well documented models of municipal bond performance that they use to determine the credit quality of financial guaranty companies. Some argue that these models assume unrealistically high levels of expected defaults, leading to a requirement to maintain overly conservative balance sheets. Others note that none of these models accurately predicted the meltdown in the subprime market. However, these models are important because they have resulted in consistent treatment among all of the financial guaranty companies.

Even if ACA Financial could demonstrate that they should be allowed to model their portfolio and operations differently than the rating agencies do, using the rating agency models would provide the municipal stakeholders an important benchmark for evaluating the runoff company's capacity to pay claims.

The negotiations that led to the Maryland's decisions on the model are not transparent. The market may well come to demand complete transparency with regard to this model and its key assumptions. ACA Financial also has agreed to report to the Maryland Insurance Administration on a semiannual basis the actual results of the runoff company compared to the results assumed and projected in the financial model. Because a company in runoff has far less of a claim to trade secrets than does a going concern, stakeholders who have been unrepresented in this process should seek that these reports be made public immediately upon receipt by the Maryland Insurance Administration.

TRANSFER OF CASHThe order includes is permission for ACA Financial to transfer approximately $47 million in cash and other valuable assets to its former parent company in exchange for release of a $100 million insurance claim. Much of the details underlying this transaction are unknown, but at a time when structured holders are foregoing $69 billion in claims in exchange for $1 billion in surplus notes, it is curious that ACA Financial's former parent company is permitted to withdraw cash from the estate, especially when the cash is equal to almost half of the purported claim.

The Maryland Insurance Administration decision to approve the transaction states that "the counterparties and other policyholders that were parties to negotiations were given all material information," and that "the settlements are fair and reasonable to the parties." The recitation of affected parties makes no mention of who, if anyone, advocated on behalf of the municipal stakeholders.

If they have not been consulted, these stakeholders may well seek to have a seat at the table. It would be only natural that any comprehensive and long-lasting settlement of claims of these estates must take into account the needs of the municipal bondholders and policyholders.

NO DISCLOSURESince the date of the announcement the only publicly available information concerning the transaction has been the publication of the order by the Maryland Insurance Administration.

Even if such disclosure is not required, it would have been comforting to those stakeholders who were not involved in the restructuring of ACA to have access to the essential terms and conditions of these transactions.

Even in runoff mode, ACA Financial remains as guarantor of more than $7 billion of obligations issued by entities in every state of the country and some territories as well. The financial condition of the guarantor is of great importance to other bondholders and policyholders of the company.

Going forward, the order states that "ACA Financial's remaining insurance obligations will consist primarily of traditional financial guaranty insurance written on municipal obligations. These remaining policies consist of 726 issues with a par value totaling $7.3 billion as of June 30, 2008."

But it is not clear if this is sufficient for ACA Financial going forward. The amount needed is dependent upon the cost of maintaining the entity and conducting appropriate surveillance, the remediation of the insured book of business, and the credit quality of the insured book of business that remains.

In the second quarter of 2008, ACA reported that the current annualized expense rate for running the company was approximately $22 million and was expected to decline to $12 million annually. It remains unclear how the company can maintain an effective surveillance and remediation effort. Assuming the $12 million expense rate is accurate, ACA would need to maintain almost $350 million in cash reserves to generate enough investment income to cover the operating burn rate.

As of June 30, ACA Financial reported $640 million of cash and investments of which the company was obligated to spend $213 million in settlement payments to swap counterparties and other third parties. Assuming $350 million is required to generate the operating cash needs of the business, then only $77 million remains in reserve to cover future defaults on the $7 billion municipal portfolio. In light of this, it is concerning that ACA's parent was able to withdraw approximately $47 million from ACA Financial as a part of this restructuring reducing the cash cushion to a mere $30 million.

In summary, before looking at this transaction as a model or framework for resolving similar subprime-based exposure issues at other financial guaranty companies, the public needs to fully understand the key terms and conditions of the transaction as described above. But also, although the Maryland Insurance Administration did its best to make sure that the company and the affected counterparties were represented in arriving at this settlement, questions remain about the apparent exclusion of any party advocating on behalf of the needs of the $7 billion of municipal policyholders (including many small individual investors), and contingent claimants.

The authors represent HRF Associates. For more information, contact Robert Smith at RSmith@hrfassociates.com or 530-620-7128.