The stock market has been abuzz with speculation over the possibility of a bailout for Ambac ( ABK). Ambac is the troubled bond insurer that recorded $5.2 billion of write-downs in the fourth quarter, and now is in jeopardy of losing its all-important AAA credit rating. Ambac is hugely affected by the credit crisis and is tied to the consumer debt and mortgage backed financial instrument markets, both of which are deteriorating. A sharp increase in defaulted mortgages could spawn a wave of defaults among bonds backed by those loans. If Ambac were not to keep their AAA rating, then their bond insurance business would struggle to stay afloat. This has ramifications that extend way beyond just Ambac. Citigroup ( C), Wachovia ( WB), and UBS ( UBS) among others need to keep Ambac healthy as the ripple effect from an Ambac bankruptcy would be massive. Oppenheimer estimates that the major banks have $70 billion of exposure to Ambac and the bonds they insure.

Clearly, Ambac losing its credit rating of AAA or declaring bankruptcy would be catastrophic. If the worst were to occur it would make the housing crisis pale in comparison. Banks act as underwriters for billions of dollars in corporate bonds of which Ambac and MBIA ( MBI) are the two main insurers. So, it would be disastrous for Ambac, to the point that these banks or the government would likely step in to keep the insurer of over $556 billion worth of bonds surviving in this extremely rough period. The banks are hoping that this $3 billion capital infusion will be enough to cover the liability of those bond sets that are in default. Looking just at the balance sheets of Citigroup, UBS, and WB, for example, shows that in 2006 these banks made almost $40 billion in combined net profit. The potential ramifications of Ambac going under would hurt these banks so badly that they would likely be willing to continue to pour money into Ambac in order to keep it operating. From their prospective, it would be better to have reduced earnings for 2 years or so as an alternative to Ambac defaulting and the disruption that would result.

By any valuation rating system Ambac will appear undervalued compared with its historical normal ranges, but clearly there is reason to be cautious in such an uncertain market environment. We cannot advise buying given the current market climate. As long as Ambac does weather the storm then it is almost certainly going to rise to more normal valuations, and it appears that Ambac is too important to the financial system for banks to allow it to go bankrupt. The real loser in this could be the bond funds who attempt to identify undervalued bonds, if indeed Ambac does lose its AAA rating the result would be an immediate deflation in bond prices backed by Ambac. These bond funds could very well collapse under the pressure of the portion of their portfolios that is insured by Ambac losing value so rapidly. It will certainly be interesting to watch all of it unfold over the coming few quarters.