The sound of credit crunching is getting louder every day.

In just the past week,

Citigroup

(C) - Get Report

and

Merrill Lynch

(MER)

have said they'll need to take nearly $20 billion in losses on risky mortgage-related paper.

Speculation about further writedowns has since spread to

Goldman Sachs

(GS) - Get Report

and

Morgan Stanley

(MS) - Get Report

, among others.

But so far, contrary to the hopes of stock-market bulls, the massive losses at Citi and Merrill haven't cleared the way for a fall recovery in financial stocks.

Instead, as credit ratings agencies such as Fitch, Moody's and Standard & Poor's issue warnings and downgrades on asset-backed securities and derivative collateralized debt obligations, the pain from the collapse of the subprime mortgage sector continues to spread.

Fitch Ratings on Monday called into question the capital reserves at financial guarantors such as

Ambac

(ABK)

,

MBIA

(MBI) - Get Report

and

Security Capital Assurance

(SCA) - Get Report

, along with closely held Financial Guaranty Insurance and CIFG Guaranty.

Fitch's review is due to take four to six weeks. If it cascades into full blown ratings downgrades, it could create another wave of forced selling in the credit markets -- this time in the $14 trillion municipal bond market.

"It's starting to feel a lot like summer," says Sid Bakst, senior portfolio manager at Weiss Peck & Greer Investments, and he's not referring to the weather.

A downgrade would only add to the pain in this once-obscure corner of the credit markets. Shares of the mortgage insurers have plunged in recent weeks, as investors worry that the firms won't be sufficiently capitalized to weather a huge storm of subprime-related mortgage losses.

Financial guarantors act like insurance companies to guarantee the high quality credit rating of many bonds. The credit quality and strength of their own balance sheets and capital reserves is essential, so a top, triple-A credit rating is an absolute necessity.

In a report, the ratings agency says that the triple-A ratings of these financial guarantors is in question, given their exposure to collateralized debt obligations that have been downgraded since early September. Some of the financial guarantors were buyers of mortgage-backed securities and related derivatives.

Many municipal funds are obliged to own only bonds guaranteed as triple-A, rated by a triple-A-rated financial guarantor. A muni market downturn could be disastrous not only for investors in these companies, but for individuals whose retirement accounts are bloated with what have been deemed bullet-proof, ratings- and guarantor-protected securities.

Much of the forced selling may not take place unless and until ratings agencies S&P and Moody's also downgrade these institutions. But typically, ratings agencies don't diverge in their opinions for long.

"This will start a chain reaction that will be very difficult to undo," says James Bianco, president of Bianco Research.

Fitch's report notes that Ambac, and SCA are moderately likely "to experience pressure in their capital cushions" due to their CDO exposures. MBIA was deemed a low probability and private companies CIFG Guaranty and FGIC are most likely to suffer, says the ratings agency.

The agency puts forth a remedy, however, and notes that if these firms are deemed at risk of falling below triple-A, they would have one month to raise capital "or execute a risk mitigation strategy," to resume the rating.

The question is how could they raise money given their current toxic status. MBIA and Ambac shares drop continually, but for the occasional short-covering bump. They are off 72% and 54% this year, respectively. SCA is down 70% year to date.

"It would be very difficult given the current state of affairs for these firms to come to the corporate bond market," says Bakst. The bonds and credit default swaps of Ambac and MBIA trade at near-distressed levels despite their double or triple-A credit ratings on the individual securities.

"It is not the most attractive environment to go out and raise capital," says Tom Abruzzo, analyst at Fitch Ratings. "We recognize that."

But he adds that raising capital isn't the only potential solution. These companies could seek out other companies to buy reinsurance protection, a common practice in the business.

"We believe companies will do whatever they can to defend their ratings," says Abruzzo.

Neither Ambac nor MBIA or SCA returned calls seeking comment.

Bianco notes the guarantors could be bailed out with loans from big banks that fear the consequences of more downgrades. But, then, he notes, that means more banks extending credit to more players exposed to the disintegrating mortgage market.

That brings things back to Citigroup, whose news pummeled the entire financial sector anew Monday. Investors seem now convinced that the worst is far from over. Long forgotten are Prince's comments from Citigroup's third-quarter earnings conference call that the bank would "return to a normal earnings environment in the fourth quarter."

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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