NEW YORK (Bloomberg) — Bermuda-based bond insurer CIFG Guaranty, which lost its AAA ratings in March, was downgraded to junk by Moody's Investors Service because of the potential for insolvency.

The ratings were cut seven levels to Ba2, two steps below investment grade, from A1 to reflect "the high likelihood that, absent material developments, the firm will fail minimum regulatory capital requirements", Moody's said in a statement.

Failing those requirements could constitute an insolvency and lead to the termination of the credit-default swap contracts the company uses to back up its bond guarantees, according to Moody's. Bond insurers are struggling to maintain capital after expanding beyond their traditional business of municipal insurance to guarantees on collateralised debt obligations, mortgage bonds and other securities that have plunged in value.

"A large part of CIFG's credit exposure was written in credit-default swap form, and contains a clause that exposes the firm to mark-to-market termination in the event of insolvency," Moody's said in the report. At current values, the termination payments would exceed claims-paying resources, Moody's said.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt or hedge against the possibility it won't. 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.

It's uncertain whether a shortfall in regulatory capital would constitute an insolvency for CIFG, Moody's said.

CIFG insured $95 billion of debt at year-end, according to its website. The new credit ratings, which affect CIFG Guaranty, CIFG Europe, and CIFG Assurance North America, remain under review, Moody's said.

"While we are very disappointed by this action, we continue to work aggressively to protect our policyholders," John Pizzarelli, chief executive officer of CIFG, said yesterday.

"We are currently in negotiations to develop strategic alternatives for problematic credits with the goal of CIFG emerging with a clean balance sheet and significantly improved capital position."

French customer-owned banks Caisse d'Epargne and Banque Populaire in December took control of CIFG Guaranty from their jointly controlled investment bank Natixis SA. The two banks added $1.5 billion of capital to the bond insurer in a bid to protect its top rating.