UPDATE 2-Fitch slashes Ambac Assurance's top "AAA" rating

(Adds Fitch analyst, background)

NEW YORK, Jan 18 (Reuters) - Fitch Ratings on Friday cut by two notches the top "AAA" rating of Ambac Assurance Corp, the insurance unit of Ambac Financial Group (ABK.N), citing the bond insurer's decision to scrap a $1 billion equity issue.

Ambac Assurance's rating was cut to "AA," the third-highest rating, from "AAA." The downgrade is a major blow to the troubled bond insurer's ability to generate new business.

Fitch also downgraded the parent company's long-term rating three notches to "A," the sixth-highest rating, from "AA." Fitch said that more rating cuts are possible.

Fitch is the first major rating firm to downgrade Ambac, which may now be at a competitive disadvantage compared with its peers in the bond insurance sector.

"The capital markets seemed to be shut down to them," said Fitch analyst Tom Abruzzo in an interview. "We were really not envisioning that to be the challenge that it became."

Ambac may also not "desire to effectively dilute its shareholders" by issuing more equity, he said.

"In the near term, they're probably going with the approach that they'll just operate at the lower rating level," he said.

New York Insurance Superintendent Eric Dinallo on Friday said the state is closely monitoring the struggles of bond insurers and would be willing to help broker cash infusions or deals to keep these players afloat. For details, see [ID:nN18507285].

The downgrade comes after the close of trading in U.S. bond markets and ahead of a U.S. holiday weekend.

The bond insurer's planned equity issuance was meant to shore up its balance sheet as securities linked to mortgages and other consumer debt suffer from higher-than-forecast losses.

Shares in Ambac Financial Group were 4.65 percent higher in late trading. (Reporting by Neil Shah; Editing by Frank McGurty)