UPDATE 2-Ambac CDS payments triggered by seizure-ISDA

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By Karen Brettell

NEW YORK, March 26 (Reuters) - State regulators that seized Ambac Financial Group's toxic assets have triggered about $2.9 billion of credit derivatives that protect against the bond insurer's main unit defaulting, a trade group said on Friday.

Ambac ABK.N will not be required to pay out on credit derivatives that it sold, but banks that tried to reduce their exposure to the company by buying credit protection on it will be able to collect on their contracts.

An auction will be held to settle the contracts, the International Swaps and Derivatives Association said.

Regulators in Wisconsin said on Thursday they were taking control of roughly $64 billion of the worst assets of Ambac Assurance Corp in a move that will preserve cash for municipal and other policy holders. For details see [ID:nN25237354].

Ambac's capital levels have become severely strained by the mortgage crisis, which forced it to make big payouts on a number of complicated repackaged mortgage bonds it had guaranteed, among other instruments.

Regulators reached agreements with bank and other firms that purchased guarantees on risky assets from Ambac to suspend payments, and ultimately tear up the contracts in exchange for cash payments that may come to around 25 cents on the dollar, plus potential future payments.

The consent of Ambac's counterparties means that the insurer will not be required to pay out the guarantees, many of which were written in the form of credit default swaps, at their full value.

Regulators had feared that any intervention in the company could trigger terms in its CDS that would require the company to pay out billions of protection it sold on risky mortgages, student loans and other assets with CDS.

Credit default swaps written on the guarantees, however, will need to be paid, after an industry committee on Friday determined that the action constituted a bankruptcy under terms of the contracts.

Banks and other counterparties bought these contracts to protect against Ambac's main unit, Ambac Assurance Corp, being unable to make good on its guarantees. (Reporting by Karen Brettell and Dan Wilchins; Editing by James Dalgleish)