Can Ambac Surive?: Credit markets explore life without bond insurer.

This post first appeared on Minyanville.

Ambac Financial (ABK) reminded investors all is still not well in the credit markets.

According to The Wall Street Journal, the bond insurer's $1.7 billion first quarter net loss was eight times greater than The Street's estimates. Notably, the company said $1 billion of its shortfall stemmed from relatively straightforward mortgage-backed securities, not complex collateralized debt obligations.

That analysts vastly underestimated Ambac's woes indicates that transparency in credit risk is still fuzzy. The reliability of the Bernanke Put has emboldened investors to shrug off what would have only months ago set off a panic. A reasonable assessment of the situation, given the extent to which the Federal Reserve and Treasury Department have proven willing to step in to support markets. Unfortunately, this crutch ignores economic reality.

The value of mortgage-backed securities is based primarily on the likelihood of borrowers making payments on the underlying loans. That cash flow is drying up as mortgage delinquencies continue to rise and falling home prices prices further depress the value of the bonds. Persistent economic weakness means these conditions will worsen.

Investors seem to be gingerly testing the hypothesis that the credit market can survive without Ambac, and maybe without its larger cousin MBIA (MBI).

Recall, however, the Fed's rationale for saving Bear Stearns (BSC). Bear's role in the multi-trillion credit derivatives market -- not its absolute size -- was the reason for the bailout. The term "counterparty risk" became a household term and the Fed feared a systemic failure if Bear were allowed to collapse on its own terms.

When Bear started falling apart, markets feared positions reliant on the solvency of entities on the other side of the transaction would lose their value. If a counterparty doesn't pick up the phone to honor its commitment, the trade is worthless.

Investors have been placated recently by loss provisions at investment banks like Merrill Lynch (MER) and Goldman Sachs (GS) for their exposure to MBIA and Ambac. This sentiment misses the point.

The risk is not simply that Ambac goes under and a few billion in additional equity gets wiped off the books of some Wall Street firms. Most have already proven willing and able to dilute existing shareholders to maintain the appearance of a strong balance sheet.

The real concern is that Ambac's collapse could reignite fears about counterparty risk, and that traders could again stop trading. Illiquid markets exacerbate pricing pressures, induce margin calls and can eventually lead to situations like the Bear Stearns run on the bank.

As the economy weakens, the value of securities dependent on mortgage payments will continue to erode. Short of outright nationalization of the mortgage market, no amount of government intervention will change this fact. The credit unwind is well underway and will continue, despite hopes the worst is over.

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