Moody’s Investors Service Monday night cut Ambac Assurance Corp.’s rating to junk status, downgrading the bond insurer to 'Ba3' from 'Baa1'. The outlook is developing.

The rating agency cited Ambac’s “weakened risk-adjusted capitalization,” pointing out its increased loss estimates on residential mortgage-backed securities. The action concludes a review for downgrade Moody’s announced on March 3.

“The rating agency noted that the claims-paying resources of Ambac remain above Moody’s expected loss estimates for the firm, though this cushion has been significantly eroded, and losses in more severe stress scenarios would exceed available resources,” Moody’s said.

In accordance with policy on below-investment grade insurers, Moody’s will remove ratings on all municipal securities wrapped by Ambac that do not have an underlying rating.

In response to the five-notch downgrade, Ambac defended the strength of the financial guarantee business model and cited its efforts in adapting to market conditions.

“While Ambac believes that Moody’s is entitled to its opinion of Ambac’s financial strength, it notes that this is the 10th such opinion change since January 2008,” the company said. “In the intervening time, Ambac has taken a number of steps to move its business model forward given the significant changes in the marketplace. In particular, Ambac has been actively refining its risk management and remediation capabilities, preparing to launch a well-capitalized, municipal-only financial guarantee subsidiary, and developing business opportunities that capitalize on the current market dislocation.

Moody’s noted that Ambac reported a statutory net loss of $4 billion in 2008. The bond insurer has qualified statutory surplus of $3.5 billion, but that “remains vulnerable to increases in case loss reserves over the near to medium terms, based on Moody’s expected loss estimates.”

In addition, Ambac’s current provisions for collateralized debt obligations of asset-backed securities are “highly sensitive to estimates of future cash flows on underlying CDO collateral and projections of the timing of claims payments many years into the future,” Moody’s said.

The agency did note that the liquidity risks of Ambac’s investment agreement business have been “largely contained,” but added that the credit profile of Ambac Assurance has deteriorated because it purchased structured finance products from the financial services business. Ambac has also seen some positive capital-accretion benefits associated with its deleveraging, but they have been offset by “downward credit migration” in its insured portfolio.

The developing outlook hinges on the performance of assets in Ambac’s insured portfolio and its ability to reduce its exposures, among other factors, Moody’s said.

“Ambac’s developing outlook reflects the potential for further deterioration in the insured portfolio as asset performance develops over the intermediate (6-18 month) term,” Moody’s said. “It also incorporates positive developments that could occur over that time, including lower variability in mortgage-related asset performance, the possibility of commutations or terminations of certain ABS CDO exposures, and/or successful remediation efforts on poorly performing RMBS transactions.”

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