UPDATE 2-Ambac shares plummet on potential Moody's cut

(Adds background, investor comment, details on competitors)

By Dan Wilchins

NEW YORK Jan 17 (Reuters) - Ambac Financial Group Inc ABK.N shares plummeted, losing more than half their value, after Moody's Investors Service said it may cut the bond insurer's debt ratings, raising fresh questions about its ability to stay in business.

Trouble with bond insurers including Ambac and rival MBIA Inc (MBI.N), whose shares fell 32 percent on Thursday, could have a massive impact on the economy, and may lift borrowing costs for consumers and local governments.

If financial insurers, who guarantee more than $2 trillion of bonds in total, filed for bankruptcy, banks that hedged with the companies may end up recording big losses on the positions. Investors in billions or perhaps even trillions of dollars of bonds would see the credit quality of their holdings eviscerated overnight.

"It would be significant and unprecedented," said Ricardo Kleinbaum, financial credit analyst at BNP Paribas in New York, who added that he saw bankruptcy for the major insurers as unlikely.

But other analysts said that it is unclear if Ambac will be able to continue operating.

"If I were a shareholder, I would worry about survivability," said Anton Schutz, president of Mendon Capital in Rochester, New York, which does not own shares of Ambac.

Ambac did not return a call seeking comment.

Ambac said on Wednesday it planned to raise $1 billion of new capital after estimating a $3.5 billion after-tax write-down for the fourth quarter that would erase nearly two-thirds of the company's net worth.

Moody's said late on Wednesday that it may cut Ambac's ratings, and will look at how industry problems affect other bond insurers as well.

The insurer said on Thursday that it is looking at whether the potential downgrade will affect its plans to raise capital. If Ambac has trouble raising capital, it may have trouble staying in business, analysts said.

Top debt ratings are crucial for Ambac's business, which involves essentially turning lower-rated bonds into top-rated bonds by insuring them. Issuers including consumer lenders and local governments often buy the insurance for their debt issues to give their securities higher debt ratings.

But those ratings are increasingly in jeopardy. In addition to Moody's, Fitch is reviewing Ambac's ratings, and without $1 billion of capital, the agency said last month it expects to cut the insurer's ratings.

Not every investor sees difficulty raising equity capital as a negative. Evercore Asset Management, whose clients own 700,000 Ambac shares, said selling equity now does not make sense, because the shares have fallen so much.

Ambac shares fell 52 percent, or $6.73, to close at $6.24, the lowest since it listed on the New York Stock Exchange in 1991. At the beginning of January 2007, shares of Ambac traded at around $89.

Shares of MBIA dropped 31.2 percent on Thursday, closing at $9.22.

Short-sellers, notably Pershing Square Capital Management's Bill Ackman and Greenlight Capital's David Einhorn, have been forecasting difficulty for bond insurers for years.

The cost of protecting Ambac obligations against default surged in the credit derivatives markets.

CDO EXPOSURE

Bond insurers generated much of their profit growth in the last decade by insuring repackaged debt known as asset-backed securities and collateralized debt obligations. But expected losses on many of those securities have surged in recent months as the subprime mortgage crisis has widened.

ACA Capital Holdings Inc, ACAH.PK a newer bond insurer that is less diversified than Ambac and carried lower ratings, said last month that Maryland state insurance regulators were making many material business decisions for its main bond insurance unit now.

Ambac said on Wednesday it would record a $3.5 billion after-tax write-down for the fourth quarter, of which about $1.1 billion is related to a series of asset-backed securities repackaged into CDOs.

That $3.5 billion wipes out nearly two-thirds of Ambac's shareholder equity, or assets minus liabilities as recorded on its balance sheet.

Ambac's market capitalization has fallen to about $634 million, making it the smallest company in the Standard & Poor's 500 index.

For a company of that size, raising $1 billion in the public convertible bond markets would be hard, and an equity issuance would be a tough sell, portfolio managers said.

That means raising private capital is likely Ambac's best bet. Ambac would be standing in a long line of U.S. financial companies seeking private capital as the subprime mortgage crisis spreads.

Many banks have successfully raised capital. Citigroup said on Tuesday it had raised $12.5 billion from sovereign wealth funds and others, while Merrill has received $12.8 billion in infusions from U.S. and foreign investors.

Investors wishing to protect Ambac parent company obligations against default for five years must pay 27 percent of the value of the debt upfront and 5 percentage points a year, up from 16 ercentage points upfront on Wednesday . (Additional reporting by Dena Aubin, Walden Siew, and Karen Brettell; editing by Braden Reddall, Leslie Gevirtz)