Buffett Bids to Back Bonds

There’s a fantastic editorial in today’s Journal regarding Warren Buffett’s offer to reinsure $800 billion of municipal bonds currently backed by monoline insurers like Ambac and MBIA.

The man is brilliant folks. He’s been sitting on billions in cash the last few years waiting for appealing investments to materialize. Municipal bond reinsurance is very appealing.

It’s a boring, low growth business, but one that dumps off stable cash flows. Ambac, MBIA, et al had a lock on the business for years. But it bored them too so they decided to chase the growing business of insuring asset-backed securities like CDOs.

Now they’ve got $1.0 trillion of exposure to asset-backed securities and only a few billion of capital to pay claims. Everyone knows losses on asset-backed securities will wipe them out. Wall Street and New York’s insurance regulator Eric Dinallo are panicked that if the companies do go bankrupt it will throw the credit markets into further turmoil.

The business of bond insurance is effectively one of renting out a AAA credit rating. Bond issuers who wish to pay lower interest rates purchase default insurance from the monolines. With “insurance” to back them up, issuers have lower default risk. Lower default risk translates into higher ratings from the likes of Moody’s and Fitch and, consequently, lower interest rates.

But an insurance policy is only as good as the insurer writing the policy.

Since the monoline insurers don’t have the cash on hand to cover expected losses for the asset-backed credits they’ve insured, all their policies, including those for ultra-safe municipals, are effectively worthless.

[Here it may be appropriate to answer a question: why, if municipal bonds have such low historical default rates, do municipalities bother purchasing insurance? Some of them wonder the same thing. The reason they have is that the amount they save on interest rates has been more than the cost of the premiums to buy insurance. Until recently anyway.]

If the monoline insurers are downgraded by the ratings agencies, then many securities they back, whose high-ratings are based in part on the insurance they’ve purchased, may themselves be downgraded. Some investors, required to hold only highly-rated fixed income securities, may be forced to sell some of these investments. Lots of forced selling would not be good for credit markets. Hence the rescue plans being discussed by Wall Street at Dinallo’s behest.

Riding to the rescue is Buffett, who made his fortune selling insurance policies and investing the premiums wisely. He knows that insuring municipal securities is a safe business that will be up for grabs as the monolines fail. So he’s using the muscle on his balance sheet, $46 billion cash ($12 billion net of debt), to write insurance policies for the safest of the safe credits.

The monolines responded coolly to Buffett’s offer of help of course. Their municipals book is the only one that’s still stable. Why should they waste money buying reinsurance on safe securities from Buffett when they’re scrambling to raise capital to cover losses on much riskier asset-backed credits?

If Buffett were willing to reinsure asset-backed securities as well, the monolines might be interested in his offer. But he doesn’t want any part of that business. He’s not a charity. He wants to cherry pick the best bonds to reinsure; the ones with the lowest default rates: the municipals.

My favorite line from the Journal editorial derives from one of Buffett’s famous investment axioms, specifically “be brave when others are fearful, and be fearful when others are brave.”

Like any good insurance salesman, Mr. Buffett wants nothing to do with the riskiest policies [insuring asset-backed securities], which makes it more likely that the bond insurers will be stuck with them. Hence the sell-off of the insurers’ stocks. Who wants to be brave where even Mr. Buffett is fearful?

Who wants to be brave indeed. It’s too early to call a bottom when it comes to CDOs and other asset-backed credits. Why do we know this? Because Buffett, who sniffs out value like a bloodhound, won’t touch ‘em with a 30-foot pole…..

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