A glance at the website of ACA Capital gives no clue to the trouble the company is in, or indeed the billions of dollars of losses it has caused at some of the world's biggest banks.

The website advertises the services provided by the bond insurance company but makes no mention of the fact that ACA, which has deals with more than 30 banks to guarantee payments on more than $60bn worth of bonds and derivatives, last night faced a deadline to pay close to $2bn or face insolvency.

Many of the banks it has done business with have already assumed it will not be able to survive, with Merrill Lynch this week taking a $1.9bn writedown to factor in such an event. Others include CIBC in Canada and France's Crédit Agricole.

ACA stopped updating its website last summer, back when it would have seemed highly unlikely that a "monoline" - or a specialist bond insurer - would be hovering on the brink of collapse six months later.

But the complicated mechanism of the credit derivatives world has led to a surprising chain of events.

Standard & Poor's rated ACA's creditworthiness as a strong single-A last June when the rating agency praised the company's "refocused, lower risk business plan" and "its sound capital position".

The credit rating lies at the heart of the bond insurance business. A company such as ACA would charge bond issuers a premium for using its strong financial position to guarantee the security.

ACA has been a big player in the market for insuring collateralised debt obligations, complex debt instruments backed by payments from other bonds or loans or assets. Each CDO is divided into different slices, with different levels of risk, and ACA has guaranteed many of the lowest-risk, or triple-A rated, slices.

Then last year, mortgage-backed bonds started to see higher levels of default than expected due to a wave of foreclosures in the risky subprime mortgage market. The higher risks translated into higher default risks for all CDOs, including triple-A rated CDOs that were supposed to be extremely safe.

ACA used to pride itself on understanding such risks. "Correlation is a critical risk factor in everything we do," James Rothman, its head of structured credit, said last June.

"We endeavour to achieve the most meaningful modelling possible on the question of correlation."

ACA announced results last November that showed enormous losses after a drop in the market value of mortgage-related securities to which it was exposed, leading to its ratings being cut. S&P cut ACA's ratings from the relatively low-risk A category to CCC, one indicating a very high risk of default.

That, in turn, meant that banks were allowed to ask the bond insurer for extra cash to back their contracts with ACA. ACA was given until last night to come up with the extra collateral.

The ACA experience highlights how quickly such chain reactions can escalate.

Other insurers such as MBIA and Ambac are also facing pressure to come up with extra capital in light of bigger than expected losses.

In the case of the two largest monolines, which until now have had much stronger ratings than ACA ever had, it is assumed they will not have to offer collateral if ratings fall a little.

There is, however, little public knowledge of the exact terms of contracts, so it is hard to assess the risks that a company will get hit by a liquidity crisis following rating cuts.

The failure to spot the problems at ACA just weeks before they emerged is a salutary reminder of the potential for further credit storms.

Monolines lend their credit rating for a fee

What is a monoline?

A company that insures against the risk of a bond or other security defaulting. For a fee, bond insurers promise to make the payments on the insured security over the lifetime of the security. American insurers MBIA and Ambac are the world's biggest.

Does an investor buy bond insurance?

No. When a company or public entity decides to issue a bond, it arranges the insurance itself - if it wants to. It then pays the bond insurer to guarantee its bonds. Because this should make the bonds safer, investors should, in theory, require lower interest payments to lend the money.

Bond insurers essentially lend their rating to less credit-worthy borrowers.

Who uses bond insurance?

The market developed in the US in the 1970s as municipal borrowers, such as small towns or regions, realised they could borrow money from big investors if they were guaranteed by bond insurers with triple-A credit ratings, the best possible. Bond insurers have developed businesses around guaranteeing payments on structured or securitised bonds. Some have also entered the derivatives market.

So what is the problem now?

Some of the assets behind the complex bonds were mortgages, including US subprime mortgages. The soaring rates of delinquencies on these mortgages means payments to the bonds have stopped. Losses on these bonds, some of which are called collateralised debt obligations have been higher than expected, and the bond insurers have to find extra capital to be sure they can meet their obligations. Without the extra capital, they could lose their triple-A ratings, and no longer be able to insure as many bonds.


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