July 24 (Bloomberg) -- MBIA Inc., Ambac Financial Group Inc. and four other bond insurers were sued by Los Angeles for allegedly conspiring to maintain a credit-rating system that led local governments to buy ``unnecessary'' policies on their bonds.

City attorney Rocky Delgadillo filed the lawsuit yesterday in Los Angeles Superior Court. The second-most populous U.S. city after New York says it seeks to recover damages it sustained by paying ``millions'' for guarantees that became worthless when the insurers lost their top credit ratings.

Borrowers in the $2.66 trillion U.S. municipal market have for decades paid insurers to guarantee their bonds, seeking lower interest costs by having AAA rated companies stand behind them. The way municipal bonds are rated has drawn fire this year from public officials who say it exaggerates default risk, forcing them to buy backing they don't need.

``This dual credit rating scheme is maintained by bond insurers to take advantage of the taxpayers, by compelling cities to purchase unnecessary bond insurance,'' Delgadillo said in a statement.

Hundreds of state and local governments were stung by higher borrowing costs this year after bond insurers, including Armonk, New York-based MBIA and Ambac, were stripped of their top credit ratings because of losses on securities linked to U.S. home loans. Officials including California Treasurer Bill Lockyer have said that insurance wouldn't be necessary if state and local bonds were assessed using the same criteria as corporate debt.

MBIA, Ambac Fall

MBIA shares dropped $1.04, or 16 percent, to $5.42 in New York Stock Exchange composite trading, while Ambac fell 28 cents, or 11 percent, to $2.19.

MBIA spokesman Willard Hill declined to comment. Ambac spokeswoman Vandana Sharma said the New York-based company doesn't comment on lawsuits filed against it.

The lawsuit is at least the second to be filed against a bond guarantor since cuts to the companies' credit-ratings roiled the municipal bond market. In Massachusetts earlier this month, an affiliate of the New England Patriots football team sued the bond insurance unit of Ambac after rates on its bonds jumped as high as 20 percent.

``California cities and public entities should not have had to buy bond insurance that is now worthless in many respects due to the failing financial conditions of the bond insurance companies,'' the city said in the complaint.

The Los Angeles lawsuit doesn't name Moody's Investors Service, Standard & Poor's, or Fitch Ratings. The other insurers named in the suit are XL Capital Assurance Inc., ACA Financial Guaranty Corp., Financial Guaranty Insurance Co. and CIFG Assurance North America Inc.

Not Disclosed

XL Capital Assurance spokesman Frank Constantinople, ACA spokesman Alan Roseman, and Michael Ballinger, a spokesman for CIFG, didn't return phone calls seeking comment. Financial Guaranty spokesman Jeff Lloyd declined to comment.

Los Angeles and other municipal borrowers were never told about bond insurers' exposure to complex financial instruments linked to home loans that undermined the guarantees they purchased, the city said in its suit.

Nanci Nishimura, an attorney with Cotchett, Pitre & McCarthy, who is working on the lawsuit, said the firm is pursuing similar complaints by other California cities that were hit with higher costs caused by ailing bond insurers.

``Public entities across the state have been hurt by this, and we will be filing more,'' Nishimura said.

Lower Rates

Local governments relied on the insurance companies' guarantees when they sold floating-rate debt, such as auction- rate bonds, whose interest rates are reset as frequently as daily, when investors such as money market funds have the opportunity to buy or sell the bonds. By effectively renting the insurer's higher rating, borrowers such as hospitals and cities were able to borrow for long-term projects at short-term rates.

Investors fled the bonds earlier this year when the insurers' credit ratings came under scrutiny. That slapped borrowers with soaring interest rates, forced them to refinance their debts and in some cases pay large fees to break interest- rate swap agreements tied to the securities.

Were the credit-rating companies to evaluate state and local governments based on the likelihood of default, taxpayers wouldn't have needed insurance, critics including Lockyer say.

Delgadillo, the city attorney, said that the bond insurance industry ``colluded to maintain a discriminatory dual credit rating system'' that costs taxpayers through ``exorbitant premiums.''

``Bond insurers' cynical use of this discriminatory credit rating system and inexcusable failure to disclose their high- risk investments in the subprime market also violates California's antitrust laws and common law,'' Delgadillo said.

Moody's Changes

Moody's last month said it will change the way it rates municipal bonds and rank them on the same scale it uses for corporate and sovereign debt. Fitch said it is studying whether to blend corporate and municipal ratings. S&P said it has already made a transition to one rating scale for all debt, and it has upgraded more than 5,300 municipal bonds since 2000.

Los Angeles, in a separate action yesterday, also sued more than 30 Wall Street banks, advisers, and other companies, seeking to recover any money it lost as a result of a conspiracy to rig the bidding on derivatives tied to municipal bonds. That suit follows similar actions by local governments including Fairfax County, Virginia.

To contact the reporter on this story: William Selway in San Francisco at wselway@bloomberg.net.

Last Updated: July 24, 2008 16:47 EDT