Buffett is not alone. There are a handful of other insurers out there doing the same thing. But only one of them is offering investors a shot a big profits. Before I detail this company, we need to take a closer look at exactly why the municipal bond market is failing.
Interest rates are soaring due to supply and demand. There is no longer adequate demand for municipal bonds, so the folks trying to sell the debt are forced to pay higher interest rates in an attempt to continue funding their projects.
Governments, schools, and pension funds which used to borrow money from investors for just three or four percent interest are suddenly finding themselves paying twelve, sixteen, or even twenty percent. They are unheard of interest rates.
I could toss out hundreds of examples from just the past week or so, but here is one that makes the point perfectly…
Typically, the Port Authority of New York and New Jersey makes an interest payment of about $80,000 each week. Last week, thanks to soaring rates, it was forced to shell out over $390,000. It will not be able to endure that pain for long. No company can. It would be cheaper to break out an American Express card.
Throughout the municipal bond market’s history, buyers were easy to come by. Lacking an adequate supply of willing buyers, the major banks supporting the bond auction would swoop in and buy whatever debt was not purchased.
The banks did it as a safe way to lock in secure income with a moderate interest rate. With nearly unlimited capital, it was a great way to put money to use.
Out of cash, out of luck
Unfortunately, the banks running these auctions are out of money. They lost billions of dollars when the mortgage industry imploded. Firms like UBS, Merrill Lynch, Goldman Sachs, and Citigroup are strapped for cash. They can no longer afford to keep the municipal bond industry afloat, especially with interest rates of just four percent.
In the past 22 years, only 13 municipal bond auctions failed. All of them failed due to credit issues, not a lack of buyers. Unfortunately, the failure rates soared to proportions nobody ever expected. In the second half of 2007, over 30 auctions were scraped. Even scarier, more than 500 auctions failed so far this year. The market literally evaporated in the course of three months.
Without support from Wall Street, the $342-billion “muni” market collapsed. It took some of the nation’s strongest bond firms with it. No matter if it was justified or not.
One of those companies isAmbac Financial Group(AMK:NYSE). It is one of the most prominent leaders in the municipal bond insurance market. As the market vanished, so did its investors.Since December, its share price has dropped by more than 80% to reach a 52-week low of $6.00. A year ago, its share price was flirting with $100.
Does the company deserve a hit to its valuation? Certainly. Much of the company’s earnings expectation was based on bad debt.
Was this downturn overdone? You bet.
That is why the stock recently surged when Standard and Poors backed the company's AAA rating. It realized the company was as strong as ever. Fortunately, even after the surge, its share price is dirt cheap.
The municipal bond market is one of the strongest financial tools this nation has. It was dealt a devastating blow, but it is not down for the count. The debt market’s correction is nearly over – as evidenced by Buffett’s recent entry – and will be rebounding in no time. Companies like Ambac that have been significantly slashed will come soaring back.
While the reassurance of its financial strength from Standard and Poors was a great benefit to shareholders, the real catalyst for Ambac’s rebound will likely be the spinoff of its municipal bond insurance division, a move that is rumored to already be in the works. Investors would then be investing solely in the firm’s strengthened municipal bond insurance business, a very appealing notion.
Most of Ambac’s trouble has come from its structured-finance unit. That is why Buffett is looking so diligently at its municipal bond business. He knows a bargain when he sees it.
So do I.
Where else can you get an opportunity to invest in an industry as strong as municipal bonds and a company as historically strong as Ambac for pennies on the dollar.
The industry has been dealt a devastating blow. Valuations have been slashed across the board. Now is the perfect chance to buy low and sell high. Invest in Ambac now, hold the position for 24 to 36 months and sell your shares as a much, much richer investor. I will be updating the positionas the story develops.
