Told in February 2008 the Oracle of Omaha wanted to take nearly $800 billion of municipal bond guaranties off their hands -- and that they should pay him a reinsurance premium for the privilege -- MBIA Inc., Ambac Financial Group Inc. and Financial Guaranty Insurance Co. all kindly said thanks, but no thanks. Beleaguered by rapidly escalating write-down losses on their guaranties of collateralized debt obligations and other structured products, the industry's leading writers were counting on the "safe" income from their core public finance books to get them through the storm.
But a year later, not only is Buffett glad he pulled the deal off the table, he's no longer certain the ostensibly "safe" municipal bonds insured by his Berkshire Hathaway Assurance Co. are quite as risk-free as they're cracked up to be.
"Local governments are going to face far tougher fiscal problems in the future than they have to date," Buffett wrote in this year's annual letter to shareholders, after disclosing BHAC closed out its first year having written $3.7 billion of primary insurance and $15.6 billion of second-to-pay policies, at rates far above the 1.5% he was offering the top writers. "Many cities and states were surely horrified when they inspected the status of their funding at year-end 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering."
Given those shortfalls, he predicts, "communities that have all of their bonds insured will be more prone to develop 'solutions' less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents."
That could be very bad news for a sector still struggling to prove it has a future. Today, Ambac and MBIA each are proposing radical restructurings that would cordon off their troubled structured products books from their public finance operations, in hopes of gaining stand-alone investment-grade ratings for the latter. For its part, FGIC ultimately had to turn to New York Insurance Superintendent Eric Dinallo to broker a deal under which it ceded its $184 billion portfolio of municipal bond guaranties to MBIA under a "cut through" reinsurance transaction.
The break-up of FGIC followed run-offs by competitors like XL Capital spinoff Security Capital Assurance and smaller bond insurer ACA Capital Holdings Inc., and portended the similar $12 billion deal Dinallo brokered for CIFG Holding Ltd. With Ambac and MBIA sidelined by downgrades, that left Assured Guaranty and Financial Security Assurance as the only "legacy" writers still doing business for most of 2008 -- two writers that intend to become one under a merger expected to close in the second quarter.
But with House Financial Services Committee Chairman Barney Frank, D-Mass., and House Education and Labor Committee Chairman George Miller, D-Calif., announcing plans for legislation establishing a federal agency to guaranty full faith and credit general obligation bonds issued by states, municipalities and other public entities with taxing power, the already weakened sector could be down for the count.
"We have always believed that the market needs three to four strong well-capitalized bond insurers and that direct federal intervention in the bond insurance market would have the effect of driving out private market solutions, thereby making the future of the municipal bond market totally dependent on the federal government, and that's not a very good outcome," Assured Chief Executive Officer Dominic Frederico said.
But interventions in the bond insurance market have grown common in the past year, as regulators attempt to keep agency downgrades from adversely impacting the $1.6 trillion municipal bond market. In addition to fears of forced selling by money market mutual funds and other institutional entities required to hold only the most highly rated investments, the coverage is needed to borrow funds for public improvement projects and other efforts to stimulate economic growth.
Another potential avenue to introduce new capacity, proposed by New York Gov. David Paterson in concert with the National League of Cities, would be to create a nonprofit mutual bond insurer owned by the municipalities. While making clear the company doesn't "have any objection to new entrants in this marketplace," MBIA Chief Financial Officer Chuck Chaplin said the company also doesn't "view not-for-profit or government-owned or -operated insurance companies as efficient or effective."
Meanwhile, while remaining an active participant in the market, Buffett said he expects to be more cautious of historical models that purport to the safety of municipal bonds while failing to recognize that "universe 'past' and universe 'current' had very different characteristics."
"Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols," Buffett said. "Our advice: Beware of geeks bearing formulas."
(By R.J. Lehmann, Washington bureau manager: raymond.lehmann@ambest.com)
