Bloomberg is reporting Ambac Soars on Reports Bailout May Happen Next Week.

Ambac Financial Group Inc., the bond insurer in rescue talks with banks, soared in New York Stock Exchange trading on optimism the company may soon reach an agreement that would save its AAA credit rating and avoid losses on $556 billion of securities it guarantees.

The New York-based company rose 16 percent after CNBC Television said a deal between Ambac and its banks may be announced Feb. 25 or Feb. 26. A group of banks is preparing to inject $2 billion to $3 billion into Ambac, the Financial Times said. The money would be part of plan to split Ambac, the newspaper said.

A rescue that enabled Ambac to retain its AAA rating for the municipal and asset-backed securities guaranty units would help banks, the insurance company and municipal debt investors avoid losses. Banks stood to lose as much as $70 billion if the top rated bond insurers, which include MBIA Inc. and FGIC Corp., lose their credit ratings, Oppenheimer & Co. analysts estimated.

Eight banks including Citigroup Inc. and UBS AG formed a group to consider providing financing, a person familiar with the matter said earlier this month. Royal Bank of Scotland Group Plc, Wachovia Corp., Barclays Plc, Societe Generale SA, BNP Paribas SA and Dresdner Bank AG, were also involved, said the person, who declined to be named because details hadn’t been set.

FGIC, which lost its top rating at Moody’s Investors Service last week, asked to be split in two to protect the ratings on municipal bonds it guarantees. MBIA yesterday said all bond insurers must eventually divide their businesses.

S&P; Futures Soar On The News

Volume surged way ahead of the news stories hitting mass media, spurring silly talk on message boards of the PPT. Here are a couple of charts I was watching real time.

S&P; 500 3 Minute Chart

S&P; 500 15 minute chart

click on chart for sharper image

More Details Emerge After Hours

After hours, additional details are emerging, mainly in the form of what the bailout might look like. MarketWatch is reporting Banks may recapitalize Ambac to save AAA rating.

A group of eight banks that are major counterparties to Ambac Financial Group may recapitalize the struggling bond insurer in a bid to save its crucial AAA rating, two people familiar with the situation said Friday.

“We have a lot of alternatives. A capital raise has always been an option to stabilize the rating,” said Vandana Sharma, a spokeswoman for Ambac. “We’re trying to do the best by all constituents, including policy-holders, shareholders and counterparties.”

Splitting up bond insurers would be difficult, pitting policyholders against shareholders of the bond insurer holding companies. “The lawyers have already begun gearing up on that one,” said Josh Rosner, a managing director at research firm Graham Fisher & Co.

One proposal involves banks injecting roughly $5 billion of capital into specific bond insurers and also providing a $10 billion line of credit.

Another idea involves commuting, or effectively tearing up, CDS contracts between banks and bond insurers. In return for dropping their claims, the banks would get a preferred equity stake in the bond insurer.

“Putting capital into an insurer is more of a contract issue between the companies involved, rather than a regulatory issue,” said James Gkonos, vice chairman of the Insurance Practice Group at law firm Saul Ewing. “That would be the simplest and most efficient way to do this.”

A forced splitting up of a bond insurer by a regulator such as the New York State Insurance Department would be an “extreme scenario” that would involve public hearings and litigation and take a long time to complete, he explained.

Still, any re-capitalization of Ambac by bank counterparties would present its own problems too, because it could dilute existing investors in the company. Such a plan would also use up capital that banks may need to help them through other problems thrown up by the global credit crunch.

“Sometimes there are problems that just can’t be solved,” Rosner said. “At some point, the market is going to realize that there is not always a best solution. There is often just a least worse solution.”

Who’s Holding The Bag?

If you want to know who’s holding the bag if the monolines fail, simply look at the who’s who list of sponsors.

Who’s Who Bagholder List

  • Citigroup (C)
  • UBS AG (UBS)
  • Royal Bank of Scotland (RBS)
  • Wachovia Corp (WB)
  • Barclays (BCS)
  • Societe Generale SA
  • BNP Paribas SA
  • Dresdner Bank AG

The two key sponsors (Citigroup and UBS) were on the list of recommended shorts by Meredith Whitney. See Analyst Meredith Whitney Asks Banks “Where’s Waldo?” for more on expected bank writedowns and dividend cuts.

Some Problems Can’t Be Solved

A $2-$3 billion infusion simply cannot fix a gaping long term $70-$150 billion problem (depending on who you believe) in the monolines. Should an attempt to do so be made, I confidently predict the banks will have to go back to the well again and again to provide additional capital.

If instead the banks agree to an upfront writeoff of the entire amount of worthless CDOs in return for an equity stake, exactly where are the banks going to come up with the necessary cash? Even if they do manage to pull that off, they will have accomplished nothing but buying a business model that is slowly dying and facing competition from Buffett as well.

“Sometimes there are problems that just can’t be solved”, and this is likely one of them. Oh sure, the market may rally a bit, especially if Moody’s, Fitch, and the S&P; keep their collective heads buried in the sand and reaffirm the AAA ratings on a mere $2 billion infusion, but long term the problem cannot go away until the entire package of CDOs guaranteed by the monolines is properly marked to market at a value close to zero.

Mike “Mish” Shedlock
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