WILMINGTON, Delaware (Reuters) - Ambac Financial Group Inc, which was the second-largest US bond insurer before suffering huge losses on risky mortgages, filed for Chapter 11 bankruptcy on Monday.

The filing cements Ambac's decline from a company that once guaranteed payments on more than $550 billion of debt, and helped state and local governments nationwide lower their borrowing costs.

Ambac had warned last week a bankruptcy filing was possible by year-end if it failed to agree with bondholders on a plan to restructure $1.62 billion of debt.

Still, the speed of the filing took some investors by surprise. Ambac shares plunged around 60 percent to 20.8 cents in New York Stock Exchange afternoon trading yesterday.

In a statement, Ambac said it was unable to raise needed capital and failed to agree with senior bondholders on a plan to conduct a "prepackaged" bankruptcy, which would have allowed for a speedy restructuring.

The New York-based company said it agreed to a nonbinding term sheet to serve as a basis for further talks. "That may allow the company to emerge from bankruptcy more expeditiously," Ambac said in a statement.

Ambac's downfall stems from its decision to chase higher profits by expanding beyond stodgy municipal bond insurance, and guaranteeing racier securities such as collateralized debt obligations crafted out of repackaged home loans.

That move backfired when the US housing market went from bubble to bust.

Ambac essentially stopped writing new business in 2008 after major credit agencies took away its "triple-A" credit rating. At the same time, claims began pouring in from the insurance it had written on the riskier financial products.

Larger rival MBIA Inc also lost its triple-A rating in 2008. Bermuda-based Assured Guaranty Ltd, backed by billionaire investor Wilbur Ross, is effectively the last insurer still writing new municipal bond business.

According to its petition filed with the US bankruptcy court in Manhattan, Ambac listed assets at negative $394.5 million, the most significant of which is a $7 billion net operating loss and associated tax benefits.

Ambac said it is planning to ask the bankruptcy court to restrict transfers of company stock and claims against the company, a move to allow it to preserve its tax benefit.

The company had for much of the last decade been a favourite of short-sellers who insisted it had too little capital to cover its exposures.

Ambac routinely dismissed these concerns, saying as recently as mid-2008 that it had "more than sufficient capital against any claim."

In March, Wisconsin Insurance Commissioner Sean Dilweg, who regulates the company's Ambac Assurance Corp unit, seized $64 billion of Ambac's worst assets and placed them in a segregated account.

On October 8, he filed a rehabilitation plan for those insurance policies, which would pay policyholders a combination of cash and notes for their claims.