The combined loss suffered by Wall Street banks on bonds backed by high-risk sub-prime mortgages could more than double to about $110 billion (£54 billion) after Moody’s, the ratings agency, gave warning that America’s biggest bond insurers were “somewhat likely” to run short of funds.

Moody’s is conducting a review of MBIA, Ambac and five of America’s other biggest securities insurers, which guarantee a mortgage bond’s interest payments in the event of a default on the home loans that back them.

In a development that will ricochet across the bond markets, the agency gave warning yesterday that the recent surge in defaults on sub-prime mortgages would probably leave some of America’s biggest bond insurers with insufficient funds to make good the payments that will be required on some of the bonds they insure.

Moody’s added that this probable funding shortfall threatened the AAA credit rating of bond insurers such as MBIA, Ambac, Security Capital Insurance and Financial Guaranty Insurance.

A decline in the bond insurers’ ratings would, in turn, wipe tens of billions of dollars off the value of the combined mortgage bond holdings of the Wall Street firms because it would send a clear signal to the market that their ability to guarantee interest payments had deteriorated.

These losses would be on top of both the $50 billion hit that they have already suffered as a result of declines in the value of the mortgage-backed securities that they own and the forecasts of further substantial losses on these portfolios next year.

Chris Whalen, of Institutional Risk Analytics, a risk-management consultancy, said that a one-notch downgrade in the credit rating of the biggest bond insurers, from AAA to AA, would wipe at least $30 billion from the value of collateralised debt obligations (CDOs) — pools of sub-prime mortgage-backed bonds — on their books.

Mr Whalen said: “Even a one-notch downgrade would be very serious because it would force everyone who owned the bonds they insured to reflect the downgrade on their books, to reflect the decline in the insurers’ ability to pay up. This would push down valuations straight away.”

The ratings downgrades would also further undermine already deteriorating confidence in the bond industry, putting additional downward pressure on bond prices, he added.

However, the total losses that Wall Street banks would suffer from a one-notch downgrade of America’s biggest mortgage bond insurers would be much higher — at about $60 billion — since CDOs make up only a portion of their home loan securities portfolios, according to Sean Egan, of Egan-Jones Ratings, a credit research consultancy.

The bulk of these additional losses would come from declines in the value of other mortgage-backed securities and structured investment vehicles (SIVs).

Although SIVs are set up as independent, self-financed entities, the banks are expected to absorb much of their forecast losses since the law dictates that the most closely related party — which they usually are — must bear ultimate responsibility for these funds.

Mr Egan said: “I don’t think the downgrades will stop at one notch. If you look at the capitalisation levels of the bond insurers and at the pipeline of expected losses from declining bond valuations, this is likely to go on and on.”

Nor would the losses from a ratings downgrade of any insurer be confined to mortgage-related securities, since they also insure corporate bonds and state and local government bonds.

In a sign of just how serious a downgrade would be, MBIA shares fell by 16 per cent, their biggest drop in more than 20 years, after the Moody’s announcement yesterday.

MBIA is America’s biggest bond insurer and a ratings downgrade would cast doubt over the ratings and value of the $653 billion of bonds that the company guarantees.

Between them, the bond insurers that Moody’s is reviewing guarantee $2.4 trillion of debt and their downgrades could cause total losses of about $200 billion across the bond market, according to Bloomberg data.

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