Jan. 21 (Bloomberg) -- The risk of European companies defaulting soared to a record on concern credit ratings cuts at bond insurers Ambac Financial Group Inc. and MBIA Inc. may trigger forced asset sales and worsen credit market turmoil.
Credit-default swaps on the Markit iTraxx Europe index of 125 companies with investment-grade ratings jumped 10.25 basis points to 82.5, according to JPMorgan Chase & Co., the highest since the index started in 2004.
Ambac was stripped of its top AAA grade by Fitch Ratings on Jan. 18 after the New York-based company abandoned plans to raise new equity. Moody's Investors Service and Standard & Poor's are reviewing Ambac and MBIA, throwing doubt on the ratings of the $2.4 trillion of debt guaranteed by bond insurers and threatening forced sales by investors that are restricted to holding the highest-grade bonds.
``The major risk for credit markets remains forced selling on the back of downgrades of the insurers,'' said Jochen Felsenheimer, the Munich-based head of credit derivatives research at UniCredit SpA, Italy's biggest bank. ``The problem right now is there seems no way out.''
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.
Ambac Assurance Corp. was lowered two levels to AA and may be reduced further, New York-based Fitch said Jan. 18. The downgrade ``reflects the significant uncertainty with respect to the company's franchise, business model and strategic direction,'' Fitch said.
Credit-default swaps on Ambac, the second-biggest insurer, soared last week to $2.6 million upfront and $500,000 a year to protect $10 million in bonds, implying a more than 70 percent chance of default in the next five years, according to a JPMorgan valuation model.
It cost $2.6 million upfront and $500,000 a year for a similar contract protecting MBIA debt, signaling traders also see a more than 70 percent default risk in the next five years.
The bond insurance industry guaranteed $100 billion of collateralized debt obligations linked to subprime mortgages, $22 billion of non-prime auto loans and $1.2 trillion of municipal debt. New York-based Merrill Lynch & Co., the world's largest brokerage, last week took $3.1 billion of writedowns on the value of default protection from bond insurers.
WestLB AG, Germany's third-biggest state-owned lender, said today it will report a full-year loss of about 1 billion euros ($1.45 billion) and shore up capital after writedowns and trading losses triggered by worst U.S. housing slump in 26 years. Credit-default swaps on the Dusseldorf-based lender rose 30 basis points to 160, according to JPMorgan.
Credit-default swaps on U.K. mortgage lender Northern Rock Plc fell today after the British government said it will guarantee a sale of bonds backed by the bank's home loans and gave bidders two weeks to come forward with proposals. The contracts dropped 25 basis points to 290, according to CMA Datavision.
The arrangement is aimed at making it easier for a private bidder such as Richard Branson's Virgin Group Ltd. to finance a purchase of Northern Rock and repay the estimated 24 billion pounds ($47 billion) in emergency funds the company borrowed from the Bank of England.
Contracts on London-based HSBC Holdings Plc, Europe's biggest bank, rose 9 basis points to 67 today, according to CMA Datavision. Frankfurt-based Deutsche Bank AG, Germany's biggest bank, rose 12 to 67, Paris-based BNP Paribas, France's largest bank, rose 9 to 56 and Zurich-based Credit Suisse Group rose 8 to 70.
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.
The Markit iTraxx Crossover Index of 50 companies with mostly high-risk, high-yield credit ratings increased 41 basis points to 491, according to JPMorgan, the highest since July.
The Markit CDX North America Investment Grade Index closed 3.5 basis points higher at a near record 110.5 on Jan. 18, according to JPMorgan.
To contact the reporters on this story: Hamish Risk in London