The Wisconsin Office of the Commissioner of Insurance has taken control of mortgage bond insurer Ambac Assurance Corp.‘s “most troubled holdings,” as the insurance commissioner phrased it.

The commandeering occurred last week, as rumors began to surface that the company may be headed for bankruptcy, which could trigger billions of dollars in losses for municipalities who invested in mortgage securities insured by Ambac.

A spokesperson for the Wisconsin insurance department called it “the largest government action taken against an insurance company ever,” according to information published by the ratings agency A.M. Best Co.

Under the order, Ambac has established a “segregated account” for the liabilities in question, primarily policies related to subprime mortgage contracts, including credit derivatives, residential mortgage-backed securities (RMBS), and other structured finance transactions.

Wisconsin Insurance Commissioner Sean Dilweg, has filed a court petition seeking authority to “rehabilitate” the assets, which total about $35 billion. In the meantime, Dilweg has suspended some $120 million in payments to holders of the contracts.

“I am taking action to protect policyholders, including investors in thousands of state and local municipal bond issues and other public finance securities, who rely on [Ambac Assurance’s] guaranty,” Dilweg said in a press statement. “I have a concrete plan for rehabilitation, and details will be reviewed in court over the coming weeks.”

The insurance commissioner says he has been closely monitoring Ambac Assurance’s capital position and financial health since the subprime mortgage crisis began resonating through the economy more than two years ago. Dilweg says the economic downturn, combined with the company’s substantial investment in, and insurance of, mortgage-related exposures damaged Ambac’s business and financial position and reduced its claims-paying resources.

These events have created a potential financial hazard to policyholders, creditors, and the public, and have resulted in significant increase in Ambac’s projected loss impairments, Dilweg explained.

Ambac Assurance Corp. (AAC) is domiciled in Wisconsin. Its parent company, Ambac Financial Group Inc. headquartered in New York, is not regulated by the Wisconsin commissioner and isn’t directly included in the commissioner’s plan for rehabilitation.

Ambac Financial, the nation’s second-largest bond insurer, said in a statement, “Management believes that it will have sufficient liquidity to satisfy its needs through the second quarter of 2011. While Ambac does not believe the segregated account rehabilitation constitutes an event of default under its bond indenture, Ambac may consider, among other things, a negotiated restructuring of its debt through a prepackaged bankruptcy proceeding or may seek bankruptcy protection without agreement concerning a plan of reorganization with major creditor groups.”