Nov. 6 (Bloomberg) -- The cost of protecting against a default by bond insurers rose after a ratings downgrade of Ambac Financial Group Inc. caused a $3.2 billion cash shortfall.

Credit-default swaps on New York-based Ambac's bond insurance unit rose higher into distressed levels, with sellers of protection demanding a mid-price of 39.5 percentage points upfront and 5 percentage points a year to protect against a default by the company for five years, according to CMA Datavision. That means it would cost about $3.95 million initially and $500,000 annually to protect $10 million of bonds.

The upfront cost was about $3.5 million yesterday. Contracts on Armonk, New York-based MBIA Inc. also rose.

The collateral required from the company after Moody's Investors Service cut its ratings four grades to Baa1 created a shortfall at a unit that sold guarantees on debt including home loans. Ambac's main regulator, the Wisconsin Office of the Commissioner of Insurance, is allowing the company to transfer money from its insurance arm to the financial services unit.

Ambac, MBIA and other bond insurers once given top credit rankings have been crippled by downgrades after losses on credit- default swaps that guarantee against losses on securities linked to mortgages.

Insurance Unit

The upfront cost of credit swaps protecting against a default by MBIA's bond insurance unit jumped 3 percentage points today to 32.75 percentage points, CMA data show.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. An increase indicates deterioration in the perception of credit quality; a decline signals the opposite.

Credit-default swaps on the Markit CDX North America Investment Grade Index, linked to the bonds of 125 companies including MBIA, rose 11.75 basis points to 195.5 basis points, CMA data show. In London, the benchmark Markit iTraxx Europe index climbed 9 basis points to 141.5 basis points, according to JPMorgan Chase & Co.

A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

To contact the reporters on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net

Last Updated: November 6, 2008 18:23 EST