The nation's second largest bond insurer Ambac Financial Group lost its AAA rating from Fitch Ratings and was put on watch for a possible downgrade at Standard & Poor's, after Ambac scrapped plans on Friday to issue $1 billion of new equity.
Ambac's planned equity issuance, which was announced Wednesday, was meant to shore up the bond insurer's balance sheet as securities linked to mortgages and other consumer debt suffer from unexpectedly high losses. Both Ambac and its largest rival MBIA were looking to raise capital as a means to head off downgrades from credit ratings agencies.
Any ratings cut could make it difficult for the companies, which act guarantors for commercial and municipal bonds, to attract new business and could have rippling effects in financial markets. The companies were scrambling to raise capital in order to bolster their financial strength and maintain their top credit ratings.
However, Ambac ditched its plan and said raising equity capital "is not an attractive option at this time" due to current market conditions and "other factors." The New York bond insurer said it continues to "evaluate its alternatives" and "remains confident" of its insured portfolio.
That decision prompted Fitch to make good on its warning that without $1 billion of new equity capital, it would reduced Ambac's rating to AA.
Ambac shares, which had risen when the equity plan was called off, trimmed their gains after word of the Fitch downgrade.
S&P also believes Ambac may need to raise funds in order to justify its current rating, and it put Ambac's ratings on review.
"Ambac continues to explore capital-raising options, but it is increasingly uncertain whether it can implement any of these over the near term," S&P said.
S&P's announcement follows a similar move by Moody's Investors Service on Wednesday. Moody's took its action after the bond insurer said it expected to post a fourth-quarter loss of $5.4 billion on its portfolio of credit derivatives in addition to actual losses of $1.1 billion on some collateralized debt obligations linked to subprime mortgages.
Moody's also is reviewing the credit rating of rival MBIA , despite its fund-raising plans.
This week, MBIA sold $1 billion of notes. It also has received a commitment for $500 million in new equity from Warburg Pincus, which also is backstopping a $500 million rights offering.
MBIA said Friday that it was "surprised" by Moody's stance as it believes its plans to raise $2 billion through capital infusions met the credit rating agencies' previously outlined requirements.
Meanwhile, the bonds issued by Ambac and other bond insurers are currently trading at "junk" levels, which is a sign that some bond investors think there is a rising risk of default. (For more details and analysis, please watch the accompanying video.)
Ambac's 30-year hybrid security, for example, was recently trading at 36 cents on the dollar.
Before Ambac's announced it would not go ahead with the equity issuance, Bank of America put out a research note which said: "Bond insurers are better off not raising capital" because such moves are extremely dilutive.
"In our view, it would be difficult for the bond insurers to earn a high-enough return on the additional capital to offset the dilution," the analysts concluded.
The Banc of America analysts also said that if the insurers opted to go this route, they may need to raise additional capital if the mortgage downturn worsens.
If Ambac or MBIA loose their AAA rating, there will likely be follow-on effects throughout the financial markets. These include the need for large investment banks such as Citigroup , Merrill Lynch and Lehman Brothers to take further writedowns on their investments as well as the potential unwinding of deals such as Banc of America's purchase of Countrywide Financial .
The municipal bond market also would be negatively impacted as many muni bond investors would be unable to invest in bonds that are not fully insured.
--CNBC's On-Air Editor Charles Gasparino contributed to this report.