UPDATE: ACA, At Heart Of Goldman Case, Had Financial Troubles

ACA Management LLC, a unit of bond insurer ACA Financial Guaranty, is at the center of the storm unleashed by the civil fraud charges filed against Goldman Sachs Group Inc. (GS) Friday.

In its complaint against Goldman Sachs, the Securities and Exchange Commission identifies ACA Management LLC, an asset-management subsidiary of ACA Financial Guaranty Corp., as the third party used to approve the subprime mortgage bonds that would form the base of a synthetic collateralized debt obligation, or CDO, involved in the case.

ACA Financial Guaranty hasn't been ACA hasn't been accused of any wrongdoing in this case.

ACA Financial Guaranty was never one of the high-profile bond insurers that were involved in some of the biggest securitization deals because it didn't have a triple-A rating. Its only rating was single-A from Standard & Poor's, which cut it to triple-C in December 2007.

A lower credit rating meant it had to pay more to raise capital, and that the company inevitably struggled to get contracts in the most coveted deals. As a result, it had to take on bigger risks than its competitors.

"Because ACA didn't have a triple-A rating from Moody's Investors, S&P or Fitch like the other monolines, they couldn't always be as competitive on a lot of transactions. They couldn't deliver enough of a pickup in spread," said a person who worked in the monoline insurance industry at the time.

"The perception was therefore that they were willing to take on more risk, that they tended to stretch a little bit."

The Wall Street Journal reported that during the fall of 2007, ACA Financial agreed to insure $6.7 billion in CDOs underwritten by Merrill Lynch, which was trying to hedge the risk of CDOs sitting on its balance sheet. At the time, ACA was insuring over $60 billion in debt securities and had only $400 million in capital and other available resources to cover claims. The newspaper also reported that other firms, including Lehman Brothers Holdings Inc., had already set aside reserves against their hedges with ACA, concerned that it would be unable to cover losses in the bonds it insured.

ACA didn't return calls for comment.

The SEC, in its complaint, says Goldman failed to disclose to investors that Paulson & Co., a hedge fund, had cherry-picked assets to go into the CDO in question and that it was betting against those underlying assets, unbeknownst to ACA.

A synthetic CDO, a popular investment vehicle during the mortgage financing boom years, invests in swaps or other non-cash assets to gain exposure to a portfolio of fixed-income assets such as bonds, residential or commercial loans.

In a statement Friday, Paulson said it wasn't involved in the marketing of the CDO program in question, and that ACA, as collateral manager, had sole authority over the selection of all collateral in the CDO. "While it's unfortunate that people lost money investing in mortgage-backed securities, Paulson has never been involved in the origination, distribution or structuring of such securities," Paulson said in an updated statement late Friday.

Goldman denies the charges against it.

In Friday's complaint, the SEC said Fabrice Tourre, Goldman's executive principally responsible for the transaction, knew of Paulson's undisclosed short interest and its role in the collateral selection process but "misled ACA into believing that Paulson invested approximately $200 million" in the equity of the transaction. This made it seem as if Paulson's interests in the collateral-selection process "were aligned with ACA's when in reality Paulson's interests were sharply conflicting," the agency said.

As early as 2007, ACA ran into financial trouble. Things took a turn for the worse in December that year when S&P cut the insurer's rating to a junk grade triple-C, saying it had "significant doubt" that the firm could come up with enough capital to meet its obligations.

The downgrade required ACA to provide more collateral to back insurance it had written, primarily in the market for credit default swaps, which provides protection against bond defaults. ACA would have had to post "at least $1.7 billion," according to a company filing with the SEC in November 2008. That figure, it seems, may have risen much higher because credit risk premiums rose sharply after that.

Amid this crisis, the Maryland Insurance Administration, which had jurisdiction over ACA, had to get involved in a restructuring of the firm. Officials at the Maryland regulator declined to comment on the ACA Management unit, citing the fact that unlike its parent, it wasn't an insurance company.

It wasn't the first time ACA had faced financial challenges stemming from the fragility of its credit rating. Back in 2004, S&P put the monoline on watch for downgrade, forcing the firm to turn to an asset-management unit of now-failed investment bank Bear Stearns for a capital injection.

After Bear Stearns Merchant Banking injected $140 million into ACA, S&P returned its outlook on the insurer's single-A rating to "stable."

As part of that deal, the Bear Stearns unit became the single largest shareholder in ACA, and obtained three seats on its 10-member board.

Bear Stearns & Co., the holding company, eventually collapsed in March 2008, in a watershed moment. Its failure, which came on the back of failed investments in the same kinds of structured finance subprime mortgage securities as those on which the SEC complaint is focused, led the Federal Reserve Bank of New York to engineer a controversial takeover of Bear Stearns by J.P. Morgan Chase & Co. (JPM).

In Friday's announcement, the SEC cites emails which suggest Goldman knew ACA might be more amenable to its plans while also providing its "brand name" and "credibility" to "help distribute this transaction."

Goldman "arranged a transaction at Paulson's request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors...Paulson's role in the portfolio selection process or its adverse economic interests," the SEC said.

Goldman "recognized that not every collateral manager would agree to the type of names [of RMBS] Paulson want[s] to use" and put its "name at risk...on a weak quality portfolio," the SEC's complaint said.

-By Anusha Shrivastava, Dow Jones Newswires; 212-416-2227; anusha.shrivastava@dowjones.com

(Susan Pulliam, Serena Ng and Randall Smith contributed to this story.)

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