NEW YORK (TheStreet) -- Bond insurer Ambac Financial Group (ABK), whose shares are trading for less than $1, moved closer to bankruptcy as an insurance regulator took control of $35 billion of its main subsidiary's liabilities.

The Wisconsin Office of the Commissioner of Insurance (OCI), which regulates the subsidiary, filed a petition for what's called rehabilitation with a Wisconsin County Circuit Court yesterday, meaning it wants to take control of the insurer's operations. It demanded the segregation of accounts between parent company Ambac Financial and Ambac Assurance Corp., the subsidiary, be established to provide a "durable solution for all policyholders."

Ambac has been teetering on the edge of bankruptcy for months after it was forced to pay billions of dollars on claims following the financial crisis. Ambac's collateralized debt obligations (CDOs) on asset-backed securities (ABS) lost the most value. Ambac's shares fell 22% to 62 cents in New York trading today.

"I am taking action to protect policyholders, including investors in thousands of state and local municipal bond issues and other public finance securities, who rely on Ambac Assurance Corp.'s guaranty," said Sean Dilweg, Wisconsin's insurance commissioner.

Dilweg said he's made plans for the rehabilitation that "will be reviewed in court over the coming weeks." The order doesn't place Ambac Assurance into rehabilitation. If it were, that would essentially mean the parent company would go bankrupt.

A frustrated Ambac Chairman Michael Callen, who had hoped to revive the bond insurer as the economy pulls out of a recession, said the company's "compliance with the direction of OCI to establish the segregated account of Ambac Assurance and to consent to the terms of the proposed settlement agreement of our CDO of ABS portfolio is the best alternative available."

Ambac's failure to agree to the terms of the Office of the Commissioner of Insurance would have led to an immediate seizure of Ambac Assurance and the inevitable bankruptcy of the parent company. In other words, Ambac had little choice in the matter as Callen's time ran out.

According to Ambac, assets moved to the segregated account include most policies insuring or relating to credit default swaps, all residential mortgages-backed securities (RMBS) obligations, policies insuring troubled credits, some student loan policies and other contingent liabilities including Ambac Assurance's liabilities as a reinsurer.

Ambac said the counterparties to credit default swaps have agreed to temporarily forebear accelerating Ambac Assurance's obligations or take any other actions because of the rehabilitation order.

Ambac said it has sufficient liquidity through the second quarter of 2011.

Still, the company said that "while Ambac does not believe the segregated-account rehabilitation constitutes an event of default under its bond indenture, Ambac may consider, among other things, a negotiated restructuring of its debt through a prepackaged bankruptcy proceeding or may seek bankruptcy protection without agreement concerning a plan of reorganization with major creditor groups."

Ambac has essentially negotiated a stay of execution by its counterparties but is still trying to determine whether it will be better off seeking bankruptcy protection. If the insurer takes the bankruptcy route, it's not clear what would be left of the group once it exited.

As for Ambac's rivals, MBIA ( MBI), whose MBIA Insurance Corp. subsidiary also files in Wisconsin, will be focused on ensuring it doesn't reach such a perilous state.

-- Reported by Gavin Magor in Jupiter, Fla.

Gavin Magor is the senior analyst responsible for assigning financial-strength ratings to insurance companies. He conducts industry analysis and supports consumer products. Magor has more than 22 years of international experience in operations and credit-risk management, commercial lending and analysis. His experience includes international assignments in Sweden, Mexico, Brazil and the U.S. He holds a master's degree in business administration from The Open University in the U.K.

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