June 19 (Bloomberg) -- Moody's Investors Service stripped MBIA Inc. and Ambac Financial Corp. of their Aaa, following Fitch Ratings and Standard & Poor's, ending the bond insurers' run of at least two decades at the top of the ratings scale.

MBIA's MBIA Insurance Corp. unit was reduced five levels to A2 from Aaa, New York-based Moody's said today in a statement. Ambac Assurance Corp. was lowered three steps to Aa3, Moody's said in a separate release. The outlook on both is negative.

The downgrades end more than seven months of speculation about whether the bond insurers would keep their top ratings at all three firms. Five of seven companies lost their top ratings as projections for losses on securities backed by home loans surged and confidence in the companies collapsed, causing municipalities to shun their insurance. The downgrades span more than $2 trillion of debt sold by issuers ranging from school districts and sewer authorities to Wall Street firms.

MBIA's downgrade reflects its ``limited financial flexibility and impaired franchise,'' Moody's analyst Jack Dorer said today in a statement. Ambac has ``significantly constrained new business prospects'' and likely will incur more losses, Dorer said.

Armonk, New York-based MBIA and Ambac of New York both said they were ``disappointed'' by Moody's decision.

``Our financial condition is very strong,'' MBIA Chief Executive Officer Jay Brown said in a statement today. ``We remain committed to maintaining capital strength for our policyholders and financial flexibility.''

Ambac said it can ``manage through the current credit crisis.''

CDOs

The bond insurers lost their top ratings after straying from the business of backing municipal bonds, which rarely default, to guaranteeing more untested securities such as collateralized debt obligations, which package pools of securities, including those backed by subprime mortgages, and slice them into pieces of varying risk.

Further downgrades may cause Citigroup Inc., Merrill Lynch & Co. and UBS AG to write down the value of insured-debt holdings by at least $10 billion, according to Meredith Whitney, an analyst at Oppenheimer & Co. in New York. Banks and insurance companies would also be required by regulators to hold more capital to protect against losses on lower-rated debt, according to analysts at Charlotte, North Carolina-based Wachovia Corp.

MBIA and Ambac were once the top two insurers of municipal debt, a mantle that has been taken by competitors Financial Security Assurance Holdings Ltd. and Assured Guaranty Ltd. Financial Security insured 64 percent of all municipal bonds sold in the U.S. during the first quarter, according to Thomson Reuters.

Losses

Combined with a slump in the value of derivatives contracts used to guarantee CDOs, the lack of new revenue weighed on the company's credit ratings. Ambac reported a $1.66 billion net loss in the first quarter after $3.1 billion in charges for subprime- mortgage securities that it insured. MBIA had a loss of $2.4 billion as the value of derivatives it sells to guarantee debt tumbled $3.58 billion.

Moody's said it was reconsidering downgrades on June 4, citing a drop in demand for the companies' insurance and their limited ability to raise capital. In response, MBIA and Ambac said they disagreed with the assessment and had no plans to raise more money.

A day later, S&P removed the AAA insurance rating from both companies.

Moody's and S&P first put the ratings of Ambac and MBIA under review in January, citing the deepening housing slump and rising losses on securities backed by home loans.

`Strongly Capitalized'

MBIA and Ambac then sold a combined $4.1 billion in shares, bonds and convertible debt in the first quarter to save their ratings. Moody's affirmed the Aaa ratings on the insurance units of MBIA in February and Ambac in March.

The capital wasn't enough to keep top rankings from Fitch, which cut Ambac to AA in January, and MBIA to AA in April. As the slump worsened, Moody's and S&P took a second look at their assessments.

In the past two quarters, MBIA's insurance unit set aside reserves of $2 billion to cover losses on $51 billion of guarantees on home-equity securities and CDOs backed by subprime mortgages.

MBIA is $2.6 billion short of its target capital level for an Aaa company, Moody's said. The rating company also said MBIA's decision to retain $1.1 billion at its holding company was ``indicative of a more aggressive capital management strategy'' and contributed to the extent of the downgrade.

Ambac is $225 million below the Aaa target level, Moody's said.

At the current rating, Ambac has a ``substantive capital cushion,'' Moody's said. MBIA is also ``strongly capitalized'' for an Aa rating, Moody's said.

To contact the reporter on this story: Christine Richard in New York at crichard5@bloomberg.net

Last Updated: June 19, 2008 19:20 EDT