It hasn't been a great year for the bond-insurance business so far. Even with Tuesday's massive gains, both Ambac Financial (NYSE: ABK) and MBIA (NYSE: MBI) remain down 70% and 33% for 2008, respectively. Good grief! I've done better playing keno in Las Vegas.

How much?
On Tuesday, Ambac announced a fourth-quarter loss of $3.26 billion, or almost four times its current total market cap. The huge losses came amid a 78% decline in underwriting premiums and a write-off of more than $5 billion on the value of credit derivatives it held on its books tied to subprime-mortgage debt. Nonetheless, some pessimism went away on Tuesday, after interim CEO Michael Callen made it clear that he's determined to keep the company alive and healthy. He said he is seeking other ways to raise funds and hopes to reclaim his company's AAA grade from ratings firm Fitch.

Ambac suffered a huge blow last week when it lost that AAA credit status. A bond insurer's rating status can be the lifeblood of its business, because it gives clients a sense of security that the company will hold true on its promise to insure bonds that other parties have issued. In a commoditized industry like bond insurance, losing such a status can mean a quick demise, and investors reacted to last week's news accordingly, by sending Ambac shares down 64% over a seven-day stretch.

Don't fight it
Part of the reason it lost its AAA rating was the scrapping of plans to raise $1 billion in equity that it needed to shore up its balance sheet. Ambac called off the plans after determining that market conditions were far too poor for raising capital, and losing a hefty chunk of current investors' stakes was the price it paid.

MBIA, on the other hand, didn't hesitate to raise much-needed capital. Earlier this month, it sold $1 billion of surplus notes that, when issued, yielded a massive 14% -- a number that sheds some light on how desperate the industry has become. The same debt now yields nearly 20%. The high yield demanded on the debt signifies how concerned investors have become with the bond-insurance industry's prospects. That 20% signifies the significant possibility of a future default.

While investors cheered Tuesday's news and sent shares of both companies surging, the excitement may be short-lived. Several highly regarded hedge-fund mangers, including David Einhorn and Bill Ackman, have expressed concern over the validity of bond insurers' credit ratings. Moody's (NYSE: MCO), Standard & Poor's -- a unit of McGraw-Hill (NYSE: MHP) -- and Fitch have all come under fire for what some consider unrealistic and even erroneous future liquidity and earnings projections that serve as the framework for credit ratings. If these claims turn out to be valid and the financial standing of these bond insurers is truly as fragile as some think it is, a total collapse suddenly doesn't seem too far-fetched. Plug your noses ... it's starting to stink in here.

Just when you thought you were safe ...
Further stoking fears over Ambac's and MBIA's futures is the recent announcement from Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) that it intends to make a foray into the bond-insurance business. With tens of billions of freely available cash and a pristine reputation, Berkshire's balance sheet makes Fort Knox look like a house of playing cards, and it undoubtedly has more than enough ammunition to weather a great deal of losses that others couldn't dream of. As the reputation of Ambac and MBIA continues to remain uncertain, any business that comes to market may indeed flock to anything attached to the Berkshire name.

The fall of these bond insurers is just the latest in the debt saga that continues to plague the market. What was once a solid and respectable business that was centered on insuring typically safe municipal bonds, Ambac and MBIA were lured into insuring the burgeoning mortgage-backed-securities industry that has now proved toxic.

Another debt-market prisoner
Ambac and MBIA face quite a predicament: Struggle to raise liquidity and convince investors you'll stay alive, only to face the prospects of competing with a titan like Berkshire Hathaway if you're blessed enough to stick around. This "lose-lose" situation puts investors squarely between a rock and a hard place. Sound familiar? Welcome to the club.

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