Buffett Proposes Cherry-Picking Bond Insurer Risks

We are late to the big news du jour, namely Warren Buffett’s proposal to rescue the muni bond business of MBIA and Ambac. The market staged a peppy rally on the announcement, no doubt due to a resumption of bullish optimism and a lack of understanding of the implications of the deal (the brush-off of AIG’s announcement of a considerably-larger-than-expected loss yesterday of nearly $5 billion due to “faulty accounting,” and the admission that the big insurer didn’t have a handle on the value of some risks, was another sign of change in sentiment).

While we has said before that Buffet would not take a stake in MBIA and Ambac, we did say he and other insurers might be interested in reinsuring or acquiring the muni bond portfolio. While there have recently been stories about the troubles municipalities are now facing due to the doubts about the bond guarantors’ future, those risks are not the cause of the monolines’ woes. The downgrade risk results from their participation in insuring CDOs, subprime debt, commercial real estate debt, and (at MBIA) certain below investment grade debt.

Picking off the best assets does nothing to address the fundamental problem; in fact, it makes the future (assuming there is one) for the monolines worse, since what they will be left with is clearly dreck.

Moreover, if I read the proposal correctly (the details are sketchy), Buffett proposed to take $9 billion in fees from the two bond insurers and put up $5 billion to capitalize the risks assumed. That looks like a negative net investment to me. He would also increase the insurance premiums charged to municipalities to 1.5 times their current level.

Even if you didn’t have the concern about what this deal does to the balance of the monolines’ risks, this looks like an awfully one-sided transaction. Which is what you’d expect, with AIG suddenly looking a bit wobbly and Buffett the only game in town.

Remember that Buffett made a lowball offer for LTCM during its crisis that was also rejected.

From Bloomberg:

Billionaire investor Warren Buffett said he offered to shore up $800 billion of municipal bonds guaranteed by troubled MBIA Inc., Ambac Financial Group Inc. and FGIC Corp. in a bid to gain 33 percent of the debt insurance market.

Buffett’s Omaha, Nebraska-based Berkshire Hathaway Inc. would assume the risk of the debt from MBIA and Ambac in exchange for charging a fee of $4.5 billion each, according to a letter to MBIA’s advisers that was obtained by Bloomberg News and confirmed by Berkshire Hathaway spokeswoman Jackie Wilson.

The offer drove U.S. stocks higher on optimism the plan would help calm credit markets and prevent a slump in the value of municipal debt. MBIA and Ambac dropped on concern Buffett’s proposal would leave them with mortgage securities that caused more than $5 billion of losses last quarter, while Berkshire would gain a municipal guaranty business that has generated profit for more than 14 years.

“He is offering to take the fattest, most profitable part of their business,” said Jerry Bruni, president and portfolio manager, at J.V. Bruni and Co. in Colorado Springs, Colorado. Bruni has $650 million under management including Berkshire shares. The firm sold MBIA last month. “I can’t imagine why they would want to do that. If I were MBIA or Ambac, this does not sound like a good offer.”

The offer excludes the bond insurers’ subprime-related obligations, Buffett told CNBC during an interview earlier today. One company has already rebuffed the proposal and the two others haven’t responded, Buffett said.

Berkshire would put up $5 billion as capital for the plan and is offering to insure the municipal debt for 1.5 times the premium charged by the bond insurers to take on the guarantee. The insurers could accept the offer and back out within 30 days for a fee, Buffett said.

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  1. Anonymous

    This update from rantings and ravings at Calculatedrisk in regard to Buffett and Sherman Act:

    Insurance Subcommittee Chairman Paul Kanjorski

    Not surprisingly, such developments have the attention of Congress — particularly of Capital Markets and Insurance Subcommittee Chairman Paul Kanjorski. Already in the midst of an ongoing investigation of state insurance regulation, Kanjorski is planning a mid-February hearing focused exclusively on the monoline sector. Senate Banking Committee Chairman Chris Dodd likewise has an eye on the bond insurers, and may be mulling steps to address their line of business.

    Questions abound, and will no doubt be asked during the forthcoming inquiries. Where were state regulators when insurers starting taking on these risks? Where was the solvency monitoring, supposedly the raison d’être of the NAIC? How is it that an industry with more than $2 trillion in insured obligations was permitted to keep so little in reserves?

    All fair questions, no doubt, but similar interrogatories also can and will be hurled in the direction of such federal authorities as Housing and Urban Development, the Securities and Exchange Commission, and the Federal Reserve. When it comes to the now-burst housing bubble, there appears no shortage of regulators who could be accused of falling asleep at the switch.



  2. Anonymous

    I must share this thought on Buffett. His corporation has $2.5 Billion invested at Moody’s, who has obviously been reluctant to downgrade the highly suspect models of bond insurers like MBIA, thus when MBIA has a market cap of $1.4 Billion (and falling rapidly) there is doubt in mind as to the limitations of conflicts of interest.

    It seems to me that Buffet and his pal Ackman were a tag team duo today slapping and kicking at these pathetic bond insurers, while offering themselves as saviors in what amounts to a hostile take over bid, which has the full blessing of these folks:

    For regulators, such as the New York Insurance Superintendent Eric Dinallo, the potential for losses is a huge concern. If ordinary investors lose money on what they believed were safe investments, or if municipal borrowers in, for example, New York State have trouble borrowing money, the political implications could be significant.

    “This is extremely important for Dinallo, as well as for his boss [Eliot Spitzer],” said one person involved in discussions. “The Buffett proposal does nothing in terms of helping out the banks, though.”

    However: “It doesn’t seem like an offer that could be easily accepted,” said Evan Rourke, municipal bond portfolio manager at MD Sass in New York. “Most of the muni guys looked at the offer and said (insurers) will never do that.”

    Under Buffett’s plan — which included a 30-day clause to allow the bond insurers to come up with a better deal — the companies would be left with a portfolio of riskier debt, including collateralized debt obligations.

    Analysts said it would be difficult for bond insurers to accept his proposal because they would have less income from their safer muni assets to offset potential losses from increasingly toxic assets like CDOs.

    Bonus Round:

    On September 23, 1998, around 11:30 a.m., LTCM received a $250 millionoffer for its assets that was to expire within an hour, at 12:30 p.m. Thepurchaser was to be a limited partnership comprising Berkshire Hathaway,American International Group, and Goldman Sachs. 12 According to theterms of the offer, management of the assets would have been under the“sole control” of the newly created partnership. According to LTCMofficials, the Fund could not be sold without stockholder approval and theapprovals could not be obtained in an hour. The offer was subsequentlywithdrawn because Berkshire Hathaway representatives were unable toalter the terms of the original agreement.According to Federal Reserve officials, the Federal Reserve did notparticipate in the evaluation of the deal. FRBNY’s president testified thathe informed an LTCM official that “There is no guarantee whatsoever thatthis consortium approach is ever going to come together.” At some point,the official telephoned FRBNY to inform it of potential legal issuesconcerning the offer. FRBNY’s president testified that he informed theLTCM official that he had only one offer to consider, the BerkshireHathaway offer, and that “a bird in the hand is worth two in the bush.”FRBNY’s president added that this type of involvement is “as close to theedge as any central banker should ever go, and [it] may be right at the edgeof getting involved in a situation and encouraging an outcome.… We can’tget involved and say this has to be the outcome.” Later in his testimony,FRBNY’s president said that he was informed that the deal did not workand that the offer was off the table

    Another exciting angle: 1998 Bailout

    Goldman Sachs, AIG and Berkshire Hathaway offered then to buy out the fund’s partners for $250 million, to inject $4 billion and to operate LTCM within Goldman Sachs’s own trading. The offer was rejected and the same day the Federal Reserve Bank of New York organized a bail out of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. The contributions from the various institutions were as follows: [2] [3]
    $300 million: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P.Morgan, Morgan Stanley, Salomon Smith Barney, UBS
    $125 million: Société Générale
    $100 million: Lehman Brothers, Paribas
    Bear Stearns declined to participate.

  3. Anonymous

    From above, here is a link and note the conclusion:

    United States General Accounting Office General Government Division
    Washington, D.C. 20548
    February 23, 2000


    Although it is unlikely that regulators could identify
    and prevent every crisis, we recommended in our LTCM report that the
    federal financial regulators work together to develop ways to enhance
    their ability to assess risks that cross traditional industry boundaries. This
    enhanced oversight, should not, however, be focused exclusively on hedge
    funds because the issues raised by LTCM were not unique to hedge funds.

    Great work boys!

  4. Anonymous

    Something’s odd.

    The bond insurers themselves were down sharply, yet financials surged initially. Surely this is a schizophrenic market reaction?

    Buffett called the bond insurers’ bluff, making it clear to everyone that the bond insurers’ emperor had no clothes, pushing them (psychologically at least) one step closer to the brink. No surprise that their stock prices took a big hit.

    But now on the other hand… something that makes further writedowns more likely, something that puts us one step closer to unleashing the “tsunami” that Deutsche Bank’s head warned of… in what way is that a good thing, which would cause financials to surge?

    You’d be tempted to say that the dumb money was going into the financials while the smart money got out of MBIA and Ambac… but only dumb money was long those two in the first place, based on nothing but Dinallo’s vague “son of MLEC” project. Perhaps now they have the sinking feeling that Buffett’s offer is Dinallo’s plan.

  5. Yves Smith

    Anon of 9:07 PM,

    I too am mystified, although this confirms my perception of equity investors, that, except in those rare downbeat times, they’ll see any scrap of news through rose-colored glasses.

    A way that a “monolines down, financials up” pattern would make sense was if Buffett’s plan (if you could call it that) would salvage the insurance subs without helping the holding cos. But Buffett’s proposal strips out the best risks, leaving the firms having disgorged more in fees than their equity. I fail to see how that can possibly help the residual risks, and therefore financial stocks.

    What this says to me is that the investors in the monolines have been following the story and everyone tunes in intermittently. And “Buffet” and “proposal” and “$5 billion” sound good.

    I’m not sure what segregating the portfolios does, absent (perhaps) create the opportunity for others ex Buffett to reinsure. And this notion sets to lie the idea that if you put the companies in runoff mode, they’d be fine (the cynic in me wonders if this is misguided idea that doing more will ameliorate a fundamentally bad situation.)

    This also falls into the category of “be careful what you wish for.” It will make the sorry state of the structured finance side more transparent, which is something the bond insurers have refused to do. Despite Ackman’s warnings, most investors are not prepared for things to be as bad as they are likely to prove to be.

  6. Anonymous

    Yves et al,

    What I have noticed is that the euqities market has gone from long the market to now a position of hope. There has been this tendency in the stock market to discount any bad news – and turn it into a ‘it’s not that bad is it’ type of argument. Any glimmer of neutral to positive news they pumped everything back up with zeal. In the last 2 months, the zeal has so far been rewarded with a slap in the face.

    To me, the Buffet episode serves to confirm what most of us blogreaders already know – that the bond insurers are going down. Buffect is in the investment business to make money so cherry picking whatever good bits is what he or anyone will do. Nothing wrong with that. In the case of MBIA and the likes, it so happens that the ONLY good bits are the muni sector of the business. Why should anyone even be suprised?

    OT – CNBC calling Buffett story as a bail out of the bond insurers yesterday … is Goldilocks running that TV network? Or simply their level of professional jouralism, if any, is suspect? They should renamed the network as BNBC – Bull(shit?) Network Business Chanell!


  7. eh

    It was obvious this was his intention from the beginning. Apparently it is not below Buffett to make money by insuring muni bonds that do not need to be insured.

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