Ambac's Downgrade May Put Cities at Risk

A downgrade of bond insurer Ambac Financial Group is likely to have far-reaching effects, making it more difficult for cities to issue new bonds and forcing further write-downs at financial services companies, analysts said Friday.

After Ambac scrapped plans to raise $1 billion in capital, Fitch Ratings cut the company's crucial financial strength rating to "AA" from "AAA."

The downgrade likely means Ambac will not underwrite any more business, said John Flahive, director of fixed income for BNY Mellon Wealth Management. Market prices of existing bonds insured by Ambac and MBIA were trading lower before the downgrade, and Flahive suggested any downgrade could accelerate the decline.

Ambac and chief competitor MBIA together insure $700 billion in municipal bonds, and MBIA's "AAA" rating is also under threat. The company issued $1 billion in bonds this week to preserve the rating, though that may not be enough to satisfy the ratings agencies. MBIA said in a statement Friday it intends to keep working toward maintaining its "AAA" rating.

Since late last year, when the agencies first raised the prospect, analysts have suggested any move to cut Ambac or MBIA below "AAA" could be disastrous. The concern is that downgrades will lead to a reduction in the value of portfolios at dozens of financial institutions, said Donald Light, a senior analyst at Celent.

"Bond insurers are the lynchpin holding together valuations of portfolios of all kinds of financial institutions," Light said.

That scenario has already played out at least once, as Merrill Lynch reduced the value of a portfolio by $3.1 billion because of investments connected to ACA Capital Holdings. ACA , with a much smaller book of business than Ambac or MBIA, was downgraded to junk status by Standard & Poor's last month.

But while downgrades threaten to send financial services firms further into a tailspin, it will also create huge problems for municipalities.

Prior to Ambac's downgrade, T.J. Marta, a fixed-income analyst at RBC Capital Markets, said a downgrade of the company would lead to downgrades of all the municipal bonds it insured. Subsequently, it will become more difficult for cities, counties and other local entities to issue debt for building projects, Marta said.

Several types of municipal issuers will be most vulnerable if they can no longer secure insurance. These are borrowers like small private schools and hospitals that are not backed by a regular tax base or revenue stream. Typically, these entities have had to secure insurance to gain credibility with the public and sell their debt.

At the very minimum the troubles of the insurers will drive up borrowing costs of cities and other local entities at a time when many are strained by weaker tax revenue, said John Atkins, a fixed-income analyst at IDEAGlobal.com.

The failures of some bond insurers could open the door for those who do not get downgraded, as municipalities look to minimize borrowing costs.

"Survivors will get long-term benefit from the near-term volatility," said Steve Stelmach, an analyst at Friedman, Billings, Ramsey.

Warren Buffett's Berkshire Hathaway could be one company that gets a boost. Buffett launched a new bond insurance business in December that has a "AAA" credit rating and a solid balance sheet. Buffett's new company also has the benefit of having no questionable loans on its books.

Late Friday, Fitch also downgraded 420 classes of asset-backed securities transactions supported by a financial guaranty policy provided by a subsidiary of Ambac.

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