US CREDIT-Ambac downgrade threatens solvency, CDS markets

By Karen Brettell

NEW YORK, Nov 7 (Reuters) - The downgrade of Ambac
Financial Group's (ABK.N) insurance arm by Moody's Investors
Service significantly increases the risk of the bond insurer
failing, and also threatens large losses in the $47 trillion
credit derivative market.

Moody's on Wednesday cut Ambac Assurance Corp's rating four
notches to "Baa1," the third-lowest investment grade, from
"Aa3," following the company's third quarter loss.

The downgrade required Ambac to post additional collateral
against some of its contracts, which created a $2.3 billion
cash shortfall at its financial services unit, according to
JPMorgan.

This was only resolved after the Wisconsin insurance
regulator allowed Ambac to transfer funds from its insurance
unit to the financial services unit to cover the collateral
needs.

"The future of Ambac remains an open question," JPMorgan
analyst Eric Beinstein said in a report on Friday.

"We believe that access to TARP money is an urgently
relevant question for the survival of the company," he added.
"The risk of an Ambac credit event has thus significantly
increased."

Since June, when Ambac was stripped of its "AAA" ratings,
the insurer's ability to write new business has come to a
virtual standstill. Continuing deterioration in housing and the
economy, meanwhile, makes it more likely the company will face
more claims on mortgage debt it has insured.

"The company's business model is essentially broken, it's
not going to be able to underwrite any significant volume of
new business at any point in the foreseeable future, which
probably suggests runoff as being at least the near-term and
intermediate status quo for them," said David Havens, desk
analyst at UBS in Stamford, Connecticut.

"The credit market conditions continue to worsen and we're
seeing a transition from unrealized losses into realized
losses, which are going to in all likelihood adversely affect
the solvency of the company," he added.

Even if the company survives, the downgrade itself is
likely to lead to a myriad of credit derivative losses.

CDO UNWINDS

Ambac sold insurance on around $60 billion of corporate,
sovereign, asset-backed and other debt, mainly using credit
default swaps.

As concerns about the company's health increase, investors
and banks that bought protection from Ambac may unwind their
deals to offset the risk of Ambac's failure, JPMorgan said.

The insurer itself, meanwhile, is also referenced in around
55 percent of synthetic Collateralized Debt Obligations --
structured deals backed by credit default swaps, the bank
added.

"Ambac's downgrade will likely lead to further rating
downgrades in the synthetic CDO space, and its spread widening
is causing further mark-to-market losses for these structured
products," said JPMorgan's Beinstein.

Investors and dealers hedging, restructuring or unwinding
these deals may send spreads on credit default swaps on
individual companies and on indexes wider.

Meanwhile Ambac's Guaranteed Investment Contracts (GICs)
were used as collateral posted against certain types of
synthetic CDOs. And these may be forced to unwind as a result
of the downgrade, Beinstein said.

"Even without failing to meet GIC's collateral
requirements, Ambac's severe ratings downgrade will lead to
synthetic CDO unwinds," he said. "As with the reference and
counterparty risks, the collateral risk increases the pressure
on spreads to widen across all credit derivative markets."

COMMUTATIONS

One potentially bright point for Ambac's liquidity would be
if it makes agreements with counterparties to tear up contracts
on risky residential mortgages.

Ambac said in a response to Moody's downgrade on Wednesday
that the rating agency failed to account for the early
termination of some of its contract exposures, and for federal
efforts to improve the liquidity of financial institutions.

"Something that could change the game and prevent them from
becoming even more unhealthy, would be to commute a substantial
number of the chunky ABS CDO exposures and risks they have,"
said UBS' Havens. "That could very substantially improve their
prospects."
(Editing by James Dalgleish)