Bond insurer trials threaten banks as Ross circles

NEW YORK (Reuters) - Commercial and investment banks could see their credit ratings cut if the bond insurers which hedge some of their assets were themselves downgraded, Standard &Poor's said on Tuesday, as billionaire investor Wilbur Ross mulled whether to invest $1 billion or more in the sector.

The S&P report drove home the importance of the bond insurers' financial health to the wider financial services industry, which has already taken more than $100 billion in write-downs on subprime related assets and bad loans.

Regulators including New York Insurance Commissioner Eric Dinallo have been in talks to shore up insurers' capital. A group of the largest banks has joined together to look for ways to shore up Ambac Financial Group Inc , the second-largest bond insurer, two people briefed on the talks said Friday.

On Tuesday, the Wall Street Journal reported that a third bond insurer -- Financial Guaranty Insurance Co, which was downgraded by Fitch Ratings last week -- was the target of another rescue bid by a group of banks, though it said the talks were in a preliminary phase.

One analyst estimated last week that U.S. financial institutions would face as much as $70 billion in new write-downs in 2008 if bond insurers lost their top "AAA" ratings.

S&P echoed concern about the ripple effect from bond insurer downgrades.

"We believe that the specific, identifiable effect on banks may be significant and, in a few cases, could lead to downgrades. Large global institutions have direct exposure to the bond insurers in a number of ways," credit analyst Tanya Azarchs said in a report.

In an interview on CNBC television, Ross, an investor who often seeks opportunity in troubled industries, alternately characterized his decision process on investing in the bond insurers as coming to a conclusion within the next few weeks or "very shortly."

Asked whether he was focusing exclusively on Ambac, Ross said he was looking at more than one company. He did not elaborate. MBIA Inc is the largest bond insurer.

POTENTIAL BIG LOSSES

Ambac shares were up 1 cent at $11.40 in afternoon trading, in a broadly declining market. MBIA shares were up 4 cents at

$15.43.

Ross told CNBC that not many people in the private sector are willing to put capital into the bond insurers, because of the potential of big losses looming for the companies.

He revealed last week that he was considering investing more than $1 billion in bond insurers, which have seen their credit ratings under attack amid a collapse in the subprime mortgage sector and the resulting lock-down in credit markets.

S&P said the highest potential losses for banks stemming from bond insurer downgrades might be in hedges that bond insurers provide for pieces of collateralized debt obligations -- complex debt comprised of a variety of assets, such as subprime mortgages.

"To date, losses that banks have reported on the CDO exposures have predominantly been on unhedged exposures," S&P said. "However, $125 billion of subprime-related CDOs hedged by bond insurers remains concentrated in the hands of a relatively small number of banks. Few banks have disclosed how much that exposure is," it added.

In the municipal bond market, banks have also provided liquidity lines to some special-purpose entities that fund muni bond investments wrapped by bond insurers, S&P said.

With investors skittish about the strength of the bond insurers that guaranteed such investments, banks are being forced to take some of the bonds back on their own balance sheets.

That could curtail the amount of liquidity banks have available for other needs, S&P said.

(Reporting by Daniel Burns, Dan Wilchins, Dena Aubin and Anastasija Johnson, editing by Gerald E. McCormick)

(c) Reuters 2008. All rights reserved. Republication or redistribution of Reuters content, including by caching, framing or similar means, is expressly prohibited without the prior written consent of Reuters. Reuters and the Reuters sphere logo are registered trademarks and trademarks of the Reuters group of companies around the world.

More US (Business) News click here