CHICAGO -(Dow Jones)- Ambac Financial Group Inc. (ABK) cut its expected subprime losses by $789 million in its first deal to cancel one of its troubled credit default swap contracts.

Ambac paid Citigroup Inc. (C), its counterparty on the deal, $850 million to cancel its contract on the face-value $1.4 billion collateralized debt obligation.

The transaction, which will cut Ambac's exposure to subprime home mortgage losses, sent its shares soaring by 34.5% recently to $3.39, and raised bond insurers overall, as more such deals now appear likely.

The original deal had Ambac agreeing to cover losses on the security, a so- called CDO squared, which packaged segments of several CDOs made up of subprime mortgages. It was the largest of three CDO squared deals Ambac covered in recent years.

Losses have skyrocketed on all three of its CDO squareds, and the company is " pursuing" options to reduce potential losses on all of them, said Ambac spokeswoman Vandana Sharma on Friday.

Its two other large CDO squared deals are each worth just under $500 million. It has a fourth, older CDO squared deal with a value of around $80 million that is performing well.

Ambac canceled its Citi CDO by paying Citi an $850 million fee, which is less than the $1.4 billion it may have ended up paying if more loans defaulted. Ambac had taken a $1 billion market-value write-down on the transaction.

As a result, Ambac will record a $150 million positive mark on the deal.

Also, Ambac said that ratings agency stress test models estimated that losses on the transaction could exceed the $850 million Ambac paid to get out of the deal, so the settlement will improve its insurance unit's excess capital position.

Other options for reducing losses on such deals include restructuring or exercising its control rights once the securities begin to underperform.

Some insurers have filed lawsuits to cancel CDO contracts, but so far Ambac has not taken that route.

The firm has already recorded $1 billion in market-value losses on the deal, which was named AA Bespoke. Most of the CDOs included were originally AA-rated but have since been reduced to junk territory. Its other two CDO squared deals were originally rated A, but have also been downgraded to junk.

Chairman and Chief Executive Michael Callen said, "The primary benefit of this agreement is that it eliminates uncertainty with respect to future losses related to this transaction. We view the final outcome as favorable in light of the numerous widely circulated models that assumed a 100% write-off for this transaction."

The move comes days after Merrill Lynch & Co. (MER) settled around $3.74 billion in mortgage securities with bond insurer Security Capital Assurance Ltd. (SCA), which will pay Merrill $500 million.

-By Lavonne Kuykendall, Dow Jones Newswires; 312-750- 4141; lavonne.kuykendall@dowjones.com

(David Benoit and Kevin Kingsbury contributed to this report.)

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  08-01-08 1105ET
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