Earlier this morning Ambac Financial Group Inc., the world’s second largest bond insurer, posted a $1.66 billion loss for the first quarter as well as operating losses that were over three times worse than what many analysts expected.  This will have a negative impact on the over $500 billion worth of bonds that Ambac insures.

Credit default swap spreads surged for the embattled bond insurer as traders increased bets that Ambac won’t be able to meet it’s bond guarantees.  It also casts serious doubts as to whether the worst of the credit crisis has finally passed, which many financial experts were claiming.

While Ambac survived it’s last threat of a ratings downgrade of it’s financial strength by raising $1 billion in cash in a sale of stock, it will grow increasingly difficult for the company to raise additional capital.  Ambac is currently seeking shareholder approval to nearly double it’s shares of outstanding stock to 650 million shares up from 350 million.

A ratings downgrade would have serious repercussions in the entire bond market.  Certain institutional investors like government pension funds are required by law to hold only AAA rated securities and would be forced to sell any Ambac insured bonds at a loss.

The flood of these bonds on the market would further drive up yields as prices fell.  Financial institutions that continue to hold these bonds would also have to revalue their portfolios and realize these investment losses on their books.

It will also increase calls for a government bailout of the bond insurance industry, like the Fed did with Bear Stearns.  However, this would do little to alleviate the underlying problems in the financial sector and would only serve to shift the risk of loss from investors to taxpayers.

In times of economic distress, investors flock to safety.  The bond market usually acts as a safe harbor for many investors but the precarious financial position of many bond insurers has many shying away from corporate and municipal debt.

Since last summer, demand for treasury securities as well as the Fed’s rate cutting campaign, has steadily driven down yields.  Demand for 1 month T-bills has been especially brisk, with a number of money market funds reluctant to invest in short term commercial paper.

Back in March, in the wake of the near collapse of Bear Sterns, the yields on 1 month T-Bills fell to 0.27%, it’s lowest in over half a century.  Yields recovered slightly in the beginning of this month but are once again below 1 percent.

With many institutional investors feeling that the stock market hasn’t hit it’s bottom yet, the short maturing T-Bill gives them a safe haven to tide their money away until they feel the time is right to jump back into stocks while sacrificing very little liquidity.  The Treasury Department has also decreased the minimum face value of it’s securities to $100, down from $1,000 as of April 7, which makes it viable purchase for a larger number of investors.

Keep in mind that this is all taking place while inflation is on the rise and that the “real” yield is actually negative.  What we have now is an upward sloping yield curve, which is a favorable situation for banks.  Banks are able to borrow short at lower rates and lend long at higher rates.  Depending on how inflation plays out, long term interest rates may even rise further in the near future.

More trouble may be brewing for credit markets in the upcoming year.  The growing fear of inflation has caused many large institutional investors to pump money into the commodities market, forcing prices upwards as the market becomes over saturated. 

The assault on the dollar in exchange markets has not helped either.  This is a huge problem with so much of our nation’s debt being held overseas.  Foreigners are becoming more  and more reluctant to hold U.S. Treasury Securities. 

Right now, the annualized rate of inflation is higher than the yields offered on Treasury Bills.  A number of central banks have expressed dismay at this and many foreign entities are considering drawing down their stocks of  dollars and dollar denominated assets.

I wrote about this type of scenario back in November when China was threatening a massive sell off of U.S. Treasury Notes as retaliation for proposed trade sanctions.  If the fixed income market becomes flooded with Treasury Securities, prices will tumble and send long term interest rates soaring.

Once it starts, it could become a domino effect, forcing other entities to get out of dollars before it’s too late.  The effect on future economic growth could be devastating.  If you think it’s hard to find credit now, you haven’t seen anything yet.