UPDATE 1-Morgan Stanley cuts Ambac target on possible CDO losses

(Recasts, adds details)

Aug 16 (Reuters) - Morgan Stanley cut its price target on two of world's largest bond insurers Ambac Financial Group Inc. (ABK.N) and MBIA Inc. (MBI.N) to reflect potential collateralized debt obligation (CDO) losses on the two companies.

The brokerage, however, said even though CDO losses are much more likely than it previously thought, overall losses are likely to be well below what the market is currently discounting in the stock price.

The brokerage, which has an "overweight" rating on Ambac, cut its price target on the stock to $92 from $100 and said Ambac could face losses of $1.3 billion to $5.0 billion.

Analyst Ken Zerbe said he was building in a subprime/CDO loss expectation of $1.8 billion pretax, which he assumed the company will take beginning in 2008 through 2011.

Zerbe, who has an "equal weight" rating on MBIA, cut his price target to $72 from $73 on the stock. He believes MBIA could experience losses of up to $1.3 billion and built in a subprime/CDO loss expectation of $165 million pretax, to be taken from 2009 to 2011.

"There are still meaningful headwinds and uncertainty facing the guarantors, but for investors who can tolerate the near-term volatility, we believe the Ambac shares provide a compelling long-term investment," Zerbe wrote in a note to clients.

Morgan Stanley also said each company has more than $1 billion of excess capital to absorb the losses. It assumes that the two guarantors will maintain their AAA credit ratings and will continue to operate as going concerns. (Reporting by Avishek Mishra, Nivedita Gupta in Bangalore)