* Chapter 11 possible this year, creditor talks continue
* Bond insurer misses $2.8 million debt payment
* Shares slide 50.4 percent (Adds closing stock price, credit default swaps)
By Jonathan Stempel
NEW YORK, Nov 1 (Reuters) - Ambac Financial Group Inc ABK.N, which was the second-largest U.S. bond insurer before suffering huge losses on risky mortgages, said it may file for bankruptcy protection as soon as this year after skipping a bond interest payment.
Ambac shares fell as much as 59.8 percent before closing down 50.4 percent, or 41.9 cents, at 41.2 cents on the New York Stock Exchange. Ambac bond prices tumbled and the cost of protecting Ambac debt against default rose.
The announcement is the latest setback for Ambac, which has struggled to stay solvent after the housing market collapse. Ambac had pursued higher profit by expanding beyond municipal bond insurance and starting to insure riskier debt. That move backfired as credit tightened and more borrowers defaulted.
In a regulatory filing, Ambac said it has been unable to raise capital to avoid bankruptcy and is in talks with a group of senior bondholders to pursue a bankruptcy filing that would preserve a $7 billion tax benefit.
Ambac said if it cannot agree on a “prepackaged” bankruptcy in the near term, it intends to seek Chapter 11 protection this year, perhaps without the support of creditors. It said this would cause $1.62 billion of debt to be payable immediately.
The New York-based company previously said it might seek a prepackaged bankruptcy, but that its liquidity might not run out until the first quarter of 2011. Failure to win creditor support could result in a a lengthy reorganization.
“Ambac has been a corpse for some time,” said Matt Fabian, managing director of Municipal Market Advisors, an independent research firm. “With the credit crisis ongoing and getting worse, it will make any kind of bankruptcy restructuring more difficult, and painful for creditors. The bankruptcy process appears to be going faster than investors expected.”
Shares of Ambac topped $70 as recently as October 2007.
Ambac and larger rival MBIA Inc (MBI.N) had been the largest bond insurers before losses on risky debt, including mortgages, caused them in 2008 to lose the “triple-A” credit ratings on which they depended to insure debt in the $2.7 trillion municipal bond market.
Ambac decided not to make a $2.8 million payment due Nov. 1 on its $75 million of 7.5 percent bonds maturing in May 2023. It said it will be in default if it fails to pay within 30 days and bondholders may demand it repay all principal.
The next interest payment on Ambac debt is due Nov. 15.
“We are actively working with an ad hoc committee of senior bondholders” toward a prepackaged bankruptcy, Ambac spokesman Peter Poillon said on Monday.
Ambac bond prices fell by about one-third on Monday, according to bond pricing service Trace.
Credit default swaps rose to 75 percent up front from 68.6 percent, plus 5 percent annually for five years, according to Markit. That means it costs $7.5 million up front plus $500,000 a year to protect $10 million of Ambac debt against default.
In March, Wisconsin Insurance Commissioner Sean Dilweg, who regulates the company’s Ambac Assurance Corp unit, seized $64 billion of Ambac’s worst assets.
On Oct. 8, he filed a rehabilitation plan for a segregated account containing those assets, which would pay policyholders a combination of cash and notes for their claims.
A state judge in Dade County, Wisconsin on Oct. 25 rejected challenges by several banks acting as trustees for bondholders to the creation of the segregated account.
Hedge funds including Aurelius Capital Management LP and King Street Capital LP that say they own more than $1 billion of residential mortgage debt insured by Ambac Assurance are suing Ambac to stop it from siphoning assets from that unit.
A spokesman for Dilweg declined to comment. The hedge fund group did not immediately respond to a request for comment.
MBIA is also in litigation, defending against an investor lawsuit over a $5.4 billion restructuring coordinated by its main regulator, the New York State Insurance Department.
Fabian said Ambac can “at least for now” cover most claims in the municipal market, but may have trouble longer-term.
“The Wisconsin proceedings make any bankruptcy proceedings for Ambac that much less predictable,” he said.
Assured Guaranty Ltd (AGO.N), backed by billionaire investor Wilbur Ross, has been effectively the last insurer to write new municipal bond business after Ambac and MBIA backed away. But it lost its triple-A rating from Standard & Poor’s on Oct. 25. (Reporting by Jonathan Stempel; additional reporting by Emily Chasan and Chris Sanders; Editing by Derek Caney, John Wallace, Dave Zimmerman, Andre Grenon and Richard Chang)