Collateralized Debt Obligations (CDO) with asset-backed securities (ABS) as collateral, a category which includes CDO-squareds, are the primary problem facing monoline insurers. While the monolines face losses beyond their initial expectations on a variety of structured finance transactions, monolines senior position in these transactions are limiting actual losses. ABS CDOs were creating using mezzanine ABS securities, many of which are already suffering massive losses.
These agreements to terminate CDS are a major positive for the monoline insurers, at least in terms of solvency. It turns an unknown into a known. Ambac's loss on the CDS in question was an unknown. Some even believed Ambac would take a total loss on the transaction. Now their loss position is known: $850 million. That's the end of it.
Beyond that is the fact that Ambac had actually written the position down by $1 billion. So the company will be booking a $150 million gain. This proves, with an actual trade, that in at least one case Ambac was being conservative in its valuation of liabilities. While not proving anything per se, its fair to interpret this as a significant positive in terms of Ambac's future mark-to-market losses.
Finanally, this should improve the capital situation at Ambac Assurance. Not only will the company record a $150 million gain, but it has eliminated a significant source of loss uncertainty.
This is all great news for municipal bond holders. If Ambac and other monolines can stabilize, even at non-AAA ratings, the market will once again see municipal insurance as having some positive value. Currently bonds insured by any of the downgraded insurers are trading as though the insurance has negative value. So any sort of stabilization would probably cause these bonds to appreciate in value.
However, I'm weary of the run-up in Ambac's stock price. The day of the announcement the stock had risen over 60% at one point, and closed Monday even higher. In order for common shareholders to get value out of Ambac, the company will have to resume writing policies. While they might be able to do reinsurance with a AA rating, the opportunities will be limited.
Could Ambac regain a AAA rating? Consider Moody's rationale for putting FSA and Assured Guaranty on negative watch, namely uncertainty surrounding the future of monoline insurance in general. So even if Ambac, or other insurers, could significantly improve their capital situation, unless it is clear to the ratings agencies that Ambac's franchise is in tact and they can resume writing new policies, they will not regain a top credit rating.