This year could be a pivotal one for the financial guarantor sector, as its response to its recent battering sets the stage for the next few years, according to an industry analyst.

“This year will better define the future of the industry as losses crystallize, corporate restructuring continues to unfold and competitive dynamics evolves further,” said Helen Remeza, a senior analyst with Moody’s Investor Services, in a statement. “This year may also witness the entry of new guarantors, lured by the absence of competition, the current lack of alternative credit-enhancement solutions and the continued demand from smaller and higher risk municipal issuers.”

Moody’s, in a new report, suggests the outlook for the financial guarantor sector is “negative,” but did note that a few “encouraging signs” exist, including the resilient demand for bond insurance in some public-finance market segments and early successes for some guarantors in remediating losses.

But Moody’s also said challenges facing some existing guarantors remain substantial, including significant credit losses, weakened market confidence, limited liquidity, litigation risk, and regulatory uncertainty. Regulators have demonstrated a willingness to work with guarantors to alleviate capital pressures, and they have encouraged some companies to settle potential claims with their counterparties, the ratings service said. “However, one cannot expect regulators to show continued forbearance if severe capital deterioration persists,” Moody’s said in a statement. Regulators ordered two companies to suspend claims payments in 2009, it said.

While the sector’s rating is “negative,” individual companies have been rated from “developing” to “negative,” based on specific considerations, including credit performance, capital and liquidity positions, the company said.

“We expect existing guarantors to continue facing an evolving environment in 2010, with some uncertainties abating,” Remeza said. “We may reposition the ratings if there is more clarity about ultimate losses, including the effects of loan put-backs, negotiated settlements and litigations.”

The rating agency suggests there is greater receptivity for guarantors with higher risk profiles than in the past. However, there is also a lower perceived value of their insurance – and thus narrower market opportunities. Should asset spreads normalize and competitive pressures increase, this situation may weaken guarantors’ future pricing power and profitability, the ratings service said.

“Nevertheless, bond insurance appears to fill market needs; as seen in 2009, some public finance issuers and investors continued to utilize bond insurance,” Remeza said.

But insurer penetration was down to 8.6% in 2009, from more than 50% a few years back, reflecting both the lower supply of financial guaranty insurance and the lessened demand for the product, according to Moody’s.