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Ambac’s (ABK) even-worse-than-expected first quarter results have shoved the monoline bond insurers back into the spotlight, and raised the question again of whether Ambac (NYSE: ABK) will be able to avoid a crippling downgrade of its debt rating.

The insurer’s dilutive share issue last month kept Moody’s and Standard & Poor’s at bay, but the latest losses could force a rethink. The FT’s Lex sees a risk that, after this latest surprise, conditions deteriorate even more and Ambac is again threatened with a downgrade further down the line. “In that scenario, capital markets would be unlikely to roll out the welcome mat. Ambac wants to raise its authorised share count to 650 million. But even if it does, and could then somehow issue the lot at a sizeable discount, proceeds might amount to only $1 billion, given the current share price of about $3.50.”

Ambac’s stock does trade well below book value. But buying in now means banking on a turnround in credit markets, muni market recovery, and Ambac’s ability to rebuild its credibility, Lex says.

That leaves plenty of scope for investors, who have caught this falling knife repeatedly over the past year, to suffer more pain.

Indeed, Moody’s Thursday said Ambac is still at risk for a downgrade, depending
on the performance of the mortgage market and Moody’s view on whether Ambac can maintain sufficient capitalization.

It said that Ambac was below its target capitalization for a Aaa rating at the end of 2007, heightening the risk of a downgrade “perhaps over the near term” if markets continue to worsen, Dow Jones Newswires reported.

And Goldman Sachs revived the issue with a note Thursday, saying both Ambac and MBIA (NYSE: MBIA) need to raise more capital in order to hang onto their AAA-ratings, according to the Wall Street Journal’s Marketbeat blog.

Eric Dinallo, the New York insurance superintendent, told the Financial Times that two companies are considering opening new bond insurance firms – a large US bank and a large private equity firm . He said the interest showed that “there is a still a business model for bond insurance”.

He told Bloomberg Television the insurers may need to raise more capital.

Meanwhile, ACA Capital (OTC:ACAH) has bought more time to sort itself out. Today it announced that it has “entered into a fourth forbearance agreement with its Structured Credit and other similarly situated counterparties, through May 30.

Under the agreement, the counterparties will continue to waive all collateral posting requirements, termination rights and policy claims relating to the rating of ACA Financial Guaranty Corporation, ACA Capital’s financial guaranty insurance subsidiary, under their respective transaction documents including any credit support annexes and similar agreements.

The company “is pleased to have reached an additional agreement with its counterparties and continues to work closely with them to develop a permanent solution to stabilize its capital position.”

Source: Monolines' All-Important Debt Rating Threatened