Troubled monoline insurer Ambac Financial Group hasn’t yet given up on saving its ratings, even if the company is split up; the guarantor will look to raise $2 billion in an emergency rights issue, the Wall Street Journal reported Tuesday. The monolines provided the top-rated portions of MBS deals with a guarantee that essentially is designed to serve as a private-party proxy for the government guarantee that exists on Fannie/Freddie/Ginnie bond issues. But the strength of that guarantee is only as good as the rating of the firm that provides it, which means that downgrades to bond insurers are wreaking havoc on the already unsteady mortgage-backed bond market, as investment-grade securities are seeing their top ratings vanish. From the Journal:

Ambac Financial Group Inc. is discussing a plan to raise at least $2 billion in much-needed capital to help the world’s second-biggest bond insurer retain its top-notch credit rating, according to people familiar with the matter. The extra cash, to be raised by selling shares to existing investors at a discount, would likely be a prelude to a trickier and lengthier move: splitting itself into two businesses. … If banks that are discussing the split with Ambac agree to “backstop,” or buy up any unsubscribed shares in the offering, they would be providing a form of contingent capital that could persuade rating companies to preserve Ambac’s high ratings. Convincing banks to commit this capital remains a hurdle, according to a person familiar with the matter. The banking group includes Citigroup Inc. and UBS AG. Additional money has been sought from other banks, this person said.

There’s obviously some reluctance, which may have something to do with an ultimatum issued last week by New York governor Eliot Spitzer, who said the monolines had three to five days to find capital or risk being split apart by regulators in an effort to protect municipal bondholders. New York Insurance Superintendent Eric Dinallo had suggested a break-up of some monolines last week as well. “We cannot allow the millions of individual Americans who invested in what was a low-risk investment [municipal bonds] lose money because of subprime excesses,â€? he said. “Nor should subprime problems cause taxpayers to unnecessarily pay more to borrow for essential capital projects.â€? But breaking up the monolines and splitting out the structured credit guaranty business isn’t likely to be an easy matter, according to the Journal’s report. In particular, at issue is what becomes the reference point for outstanding credit default swaps:

At issue are credit default swaps that act as a form of protection against a default by Ambac on its obligations or on debt it issued to fund its business. Friday, protection on Ambac’s bond-insurance unit cost $468,000 annually, from $358,000 three months ago, according to data from Markit Group. The increases mean that hedge funds and other investors that bought these swaps to bet on a deterioration in Ambac’s financial health have profited as fears over the bond insurers’ solvency have grown. Some of those profits could increase — or evaporate — if the bond insurers separate their municipal-bond guaranty business from their mortgage-related guaranty business, say credit analysts. … “A lot of investors put on hedges or speculative bets that the bond insurers wouldn’t be credit-worthy, and there’s a possibility some of those bets could become worthless” if the swaps end up referencing the stronger municipal-bond guaranty business, says Brian Yelvington, an analyst with debt-research firm CreditSights Inc.

All of which might explain why Bill Ackman, whose short position on MBIA is now the stuff of Wall Street legend, has suddenly gone AWOL. Not that those in a short position would be the only losers in such an outcome. The ratings on RMBS and related derivatives would probably slide further into oblivion if such a move took place — in essence, the strong ratings many senior tranches in RMBS issues recieved were tied to the financial strength of the monoline issuing the guaranty, strength that was largely the result of the municipal bond book of business. Bloomberg reported that between the markets four largest players, the monolines insure roughly $580 billion of non-municipal debt:

“This is one of the worst possible outcomes for the market,” Gregory Peters, head of credit strategy at Morgan Stanley in New York, said in a telephone interview. Lower ratings would force banks that own the mortgage-backed debt to write down the value of the securities by as much as $35 billion, he estimated.