3rd UPDATE:Ambac Mulls Bankruptcy As It Skips Interest Payment

Ambac Financial Group Inc. (ABK) warned Monday it may file for Chapter 11 by the end of the year if it is unable to reach an accord on a faster pre-packaged bankruptcy agreement with its debtholders.

The announcement came as Ambac, a bond insurer that sold protection on mortgage securities, said its board had voted to skip a $2.8 million interest payment on senior notes due in 2023. The payment was due to be made Monday; if the insurer still hasn't paid in 30 days, it would be in default and its debtors could accelerate the maturity of the notes.

The decision to skip the interest payment appears to be an attempt to force the hand of Ambac's debtholders. The company, whose guarantees on mortgage securities have soured as homeowners have fallen behind on their loans, had already said it had been attempting to negotiate a pre-packaged bankruptcy with a group of its senior debtholders. But the threat of a default places additional pressure on creditors who could face a lengthy, costly fight in court if they don't agree to such a pre-packaged arrangement.

"Certainly to an extent there's some posturing, but it's a coherent argument that either [debtholders] agree to some sort of pre-packaged arrangement or else head into Chapter 11," said Rob Haines, an insurance analyst at CreditSights. In Chapter 11, he said, "any kind of reorganization becomes that much more difficult."

Ambac said in a securities filing Monday that it intends before the 30-day window closes to either pay the skipped interest payment, file for Chapter 11 bankruptcy without a prior agreement with its creditors, or reach an agreement and file a pre-packaged bankruptcy. A pre-packaged bankruptcy is negotiated with creditors before the filing and therefore has their substantial approval, eliminating the need for a lengthy court fight.

Elsewhere in the filing, the company said it "intends to file for bankruptcy under Chapter 11 of the United States Bankruptcy Code prior to the end of the year" whether or not it reaches a pre-packaged deal.

If Ambac doesn't reach an agreement with holders of its debt, a bankruptcy-court fight between the creditors and the Ambac holding company would be complicated by the obligations Ambac's operating subsidiary has to policyholders.

As capital at Ambac ran short, the subsidiary was seized by its regulator in Wisconsin and placed into "rehabilitation." That process is overseen by a Wisconsin court and the Wisconsin insurance regulator; the regulator would likely argue that the funds held by the operating company are due to policyholders ahead of debtholders.

Debtholders may feel the Wisconsin regulator's desire to avoid a legal fight may give the regulator incentive to release some portion of those funds to the holding company as the 30-day deadline approaches.

The Wisconsin insurance commissioner, Sean Dilweg, had no comment Monday morning.

Further complicating the decision for Ambac's debtholders are $7 billion of earlier net operating losses. The losses, perversely, are now an asset: They can be used to reduce taxes the company might pay if it were to return to a profit. The Internal Revenue Service, however, places restrictions on how they can be used. One trigger that would limit their use would be a bankruptcy that replaces debt with equity and hands a substantial amount of new shares to any investors that already owned 5% of the stock.

Ambac shares fell by 39% to 51 cents in afternoon trading.

Ambac said "several factors" will influence which path it takes, including "the status of negotiations with the ad hoc committee of senior debt holders and actions required to preserve the" tax benefit of the net operating losses.

Ambac had total indebtedness of $1.62 billion as of June 30.

Ambac and its regulator are also fighting in the Wisconsin court with some of Ambac's policyholders over a plan to segregate $50 billion of its policies backing structured securities. The commissioner announced a plan in October that would allow claimholders of those segregated policies to receive 25% of their claims in cash and 75% in the form of 10-year notes with a 5.1% coupon. The idea is to preserve enough cash so the bond insurance unit can continue to pay claims on the rest of its policies.

Ambac's bond insurance unit hasn't underwritten new business since mid-2008.

-By Erik Holm, Dow Jones Newswires; 212-416-2892; [e-mail]

(Michael Aneiro and Matt Jarzemsky contributed to this article.)