Nov. 19 (Bloomberg) -- Ambac Financial Group Inc., the second-largest bond insurer by outstanding guarantees, agreed to pay $1 billion in cash to cancel default protection on $3.5 billion of collateralized debt obligations, further freeing itself from the largest source of losses in its industry.

The settlement will result in positive adjustments to the Ambac's mark-to-market and impairment reserves, and improve its standing in rating-firm models, according to a statement today from the New York-based company.

Ambac and rivals including Syncora Holdings Ltd. and FGIC Corp., after being stripped of AAA ratings because of their CDO guarantees, have been able to cancel some of their contracts on mortgage-tied CDOs at discounts to their projected losses. In some cases, the banks with the protection also have benefited, after marking down the guarantees to reflect the insurers' declining creditworthiness amid surging U.S. foreclosures.

``My immediate focus as Ambac's new CEO is to restore confidence in our balance sheet through aggressive risk reduction,'' Chief Executive Officer David Wallis said in the statement.

After the deals, the company's guarantees on CDOs composed of asset-backed securities fell to $26.5 billion, Vandana Sharma, a spokeswoman, said in a telephone interview. She declined to name the counterparties on the canceled contracts.

Citigroup Payment

In August, Ambac paid Citigroup Inc. $850 million to extricate itself from a $1.4 billion CDO guarantee.

Ambac's ``exposures in the U.S. residential mortgage sector and particularly the related collateralized debt obligation structures have been a source of significant and comparatively greater-than-competitor losses and will continue to expose the company'' to potentially greater-than-expected losses, Standard & Poor's said in downgrading the company earlier today.

CDOs repackage assets such as mortgage bonds and buyout loans into new debt with varying risks. The debt, much of which was tied to subprime-mortgage securities, has been the largest source of more than $966 billion of writedowns and credit losses reported since the start of last year by global financial firms.

Ambac today fell below $1 a share for the first time since going public in 1991 after its insurance rating was cut three levels to A by S&P. The shares declined 38 cents to 76 cents as of 4:15 p.m. in New York Stock Exchange composite trading, though they rose as high as $1.09 in late trading.

The shares are down 97 percent over the past 12 months.

Moody's Investors Service cut Ambac on Nov. 6 to Baa1, two steps lower than S&P's current ranking, prompting the bond insurer to post collateral and terminate contracts by shifting cash from its guarantee unit to its investment division.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net

Last Updated: November 19, 2008 18:14 EST