Like other bond insurers, Ambac got into trouble by moving beyond guaranteeing safe municipal bonds and insuring risky subprime-related debt. The resulting loses have threatened Ambac's triple A rating, which it needs to attract new clients.
Ambac's current clients, including many of the banks involved in the rescue effort, were worried that a downgrade of Ambac would force them to write down more of their own subprime-related debt. Citigroup and Barclays are among the banks leading the rescue effort that held these risky bonds, known as collateralized debt obligations, or CDOs, enhanced by Ambac's Triple A rating.
Banks have had to revise earlier bailout proposals for Ambac because some or all of the three major ratings agencies--Moody's, Standard & Poor's and Fitch--weren't satisfied with the structure given the amount of capital the banks were putting into the transaction.
As reported by CNBC, the initial deal split Ambac into two companies, one that insured municipal bonds and another that insured the risky and price-depressed CDOs. Under a revised plan, Ambac will remain a single entity instead of splitting into a good-bank/bad bank type operation.
An Ambac rescue would be a big victory for New York State Insurance Commissioner Eric Dinallo, who has been goading Wall Street to work out a deal for weeks.
MBIA, the largest bond insurer, has recently raised more then $2.5 billion of capital from investors to help offset losses and has taken other measures to boost capital, such as eliminating its dividend.
Still, some analysts are skeptical that even with new capital, downgrades of bond insurers can't be avoided in the future. That's because they may face more losses from insuring CDOs and other bonds that are packed with depressed subprime loans.
People inside the New York State insurance department, which has taken the lead in trying to prop up the insurers, say both MBIA and Ambac have enough assets to cover losses stemming from their insurance of depressed collaterialized debt obligations, or CDOs, held by large banks like Citigroup.
The bigger question is whether these firms can compete with ratings less than triple-A, particularly now that the bond insurance business will be focusing on covering bonds of municipal governments. Many large investors of municipal debt can only hold securities with triple-A ratings.
Meanwhile, a downgrade of MBIA and Ambac could pose big problems for the banks that hold bonds they insure. Analyst Meredith Whitney said recently that the downgrades could cause writedowns of another $75 billion at the big banks.