The Wall Street Journal-20080202-The Subprime Cleanup Intensifies- Time Is Growing Short In Big Banks- Bailout Of Bond Insurer Ambac

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The Subprime Cleanup Intensifies; Time Is Growing Short In Big Banks' Bailout Of Bond Insurer Ambac

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A group of major banks is racing against a deadline as they work on a possible bailout of the No. 2 bond insurer.

The banks are seeking to preserve the top-notch credit rating of Ambac Financial Group Inc., which has been put at risk by the snowballing impact of downgrades on mortgage bonds. This in turn makes the bond insurers' positions more precarious.

If the bond insurers are downgraded, Wall Street could face an additional $40 billion to $70 billion in losses on top of the $100 billion it has already suffered.

The crisis illustrates the symbiotic relationship between the bond- rating firms and the bond insurers, which include Ambac and the No. 1, MBIA Inc. This relationship proved very lucrative during the boom time for the housing market, but now their interests are diverging, and the resulting spiral could lead to billions more in losses.

The relationship changed last year when major ratings firms began to raise their estimates of losses for securities backed by subprime mortgages. The firms, Moody's Investors Service, a unit of Moody's Corp.; McGraw Hill Cos.' Standard & Poor's, and Fimalac SA's Fitch Ratings, had given many of these securities their top, triple-A, rating. Bond insurers had guaranteed the principal and interest payments on many of these securities. Because the chance for default was slim, the insurers didn't have to set aside much capital to protect against losses.

But when securities they've insured are deemed more risky, that can force the bond insurers to set aside more capital. And if they don't have it and can't get it, the insurers are at risk of losing their own triple-A ratings, which are essential for their business.

This threat has loomed larger as the ratings firms' view of the housing market worsened, and they lowered their ratings on even more securities tied to mortgages, including those insured by the bond insurers. And when that happens, bond insurers effectively had to put up more capital for the bonds they were holding. Moody's prepared investors for bond-insurer downgrades in a research note Thursday and subsequent investor call Friday.

Some firms "may be unable to restore financial strength to levels consistent with a Aaa rating," the firm wrote. Moody's is likely to make decisions on downgrades this month, it said, possibly sooner in the month for insurers having trouble raising capital.

With this deadline looming, there are efforts to break that cycle by bailing out the bond insurers. One effort involves a consortium of banks working on a possible bailout of Ambac in a move that would provide the company with a pool of capital necessary to avoid a potential downgrade, according to people familiar with the situation.

Ambac recently lost the top rating from Fitch Ratings and has been placed on watch for a possible downgrade by Moody's. The company recently said it was in talks with "very credible" potential partners to supply needed capital. Ambac didn't return a call seeking comment. Greenhill & Co., a boutique investment bank, is working with the banks. A spokesman for the company declined to comment. No formal contract has been signed and the plan could still change or include a different mix of banks.

The consortium is likely to include Citigroup Inc., Dresdner Bank, BNP Paribas SA, Royal Bank of Scotland Group PLC, Wachovia Corp., Barclays PLC and UBS AG.

Treasury Prices Rise

On Economic Concern

Treasury-bond prices were driven higher Friday by escalating concerns over the weakening economy and the health of the financial system, though they ended off intraday highs as stocks posted gains. Gains were led by the two-year note, which rose 6/32 point to 100 3/32, with its yield falling to 2.081%. The benchmark 10-year note rose 12/32 to yield 3.598%.

-- Deborah Lynn Blumberg

Fitch Cuts Ratings

Fitch Ratings said it could cut the ratings on $139 billion of mortgage bonds backed by subprime home loans made in 2006 and 2007 amid worsening conditions for risky borrowers. Fitch estimates average losses on mortgage bonds backed by subprime home loans at 21% for loans originated in 2006 and 26% for loans originated last year.

-- Kathy Shwiff

(See related article: "Did UBS Improperly Book Mortgage Prices? Several Probes Expand" -- WSJ February 2, 2008)