Ambac Assurance Corp. (AAC) is handing over its subprime mortgage-related contracts to its state a regulator.

The contracts could total about $35 billion and have triggered market speculation that the payment could potentially lead to the collapse of the second-largest bond insurer, which would trigger losses for municipal noteholders.

The Wisconsin Office of the Commissioner of Insurance ordered the handover to “protect policyholders, including investors in thousands of state and local municipal bond issues,” according to a separate statement.  

It will suspend payments totaling about $120 million for March to holders of these contracts. These policy holders include banks, pension funds, hedge funds and other insurance companies. As long as the regulator is overseeing these contracts, the monthly payments beyond March are also suspended.

AAC will set up a segregated account for certain policies insuring or relating to credit default swaps;  all of its RMBS obligations; (iii) certain other identified policies insuring troubled credits; (iv) certain student loan policies; and certain reinsurance agreements.

The segregated account is supported by a $2 billion secured note issued by Ambac and an aggregate excess of loss reinsurance agreement provided by Ambac.   

"The actions taken today, together with the proposed settlement if effected, commute substantially all of our CDO of ABS exposure at a substantial discount to the expected present value of potential claims,” said Michael Callen, chairman of the board of directors at Ambac.

Callen added that virtually the entire insured municipal portfolio remains outside the rehabilitation proceedings.  

The proposed settlement agreement with CDO of ABS counterparties provides that Ambac will pay $2.6 billion in cash and $2.0 billion of newly issued surplus notes. 

The surplus notes will have a maturity date of ten years from the date of the closing. Interest on the surplus notes will be payable at the annual rate of 5.1%.

Counterparties to credit default swaps insured by AAC representing a significant portion of the net notional amount outstanding as of Dec. 31 have agreed to temporarily forebear from accelerating the obligations of AAC under such credit default swaps or asserting any claims against AAC or any affiliate of AAC based upon the segregated account rehabilitation proceedings.

In its statement, Ambac said that it believes that it will have sufficient liquidity to satisfy its needs through the second quarter of 2011 but added that it is now unlikely that it will be able to make dividend payments for the foreseeable future.

Ambac does not believe the segregated account rehabilitation constitutes an event of default under its bond indenture, but it will nonetheless consider, among other things, a negotiated restructuring of its debt through a prepackaged bankruptcy proceeding or seek bankruptcy protection without agreement concerning a plan of reorganization with major creditor groups.

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