Wilbur Ross’s monopoly in municipal-bond insurance won’t guarantee higher profits.
The 72-year-old billionaire’s Assured Guaranty Ltd. is alone in the $2.8 trillion debt market after Warren Buffett, 80, stopped his Berkshire Hathaway Assurance Co. from backing new issues. After entering the industry in December 2007 with fresh capital as leaders Ambac Financial Group Inc. and MBIA Inc. faltered, Buffett said last year that deteriorating state and local finances had made the business “dangerous.”
Ross pledged $1 billion to Assured in 2008 as its second-largest shareholder, priming it for growth. He may find profit elusive after the loss by MBIA and Ambac of their top credit ratings dented confidence in insurance, the recession boosted defaults, and a ratings revision by Moody’s Investors Service and record-low tax-exempt yields cut demand for coverage.
“Assured Guaranty may have a monopoly, but it doesn’t have a high-growth business,” said Richard Larkin, director of credit analysis at Herbert J. Sims & Co. in Iselin, New Jersey, which manages $1 billion of bond investments. “If they’re running lean and mean and stay out of trouble, the business can probably make money.”
Municipal failures have become a concern in an economic slump that began in December 2007. Forty-six issuers have defaulted on about $1.7 billion of municipal bonds this year, the Distressed Debt Securities Newsletter said this month. Typically, $1 billion of munis fail in a year, it said.
Driving defaults is declining tax revenue. Collections by states in April, May and June were 17.2 percent less than the same period two years ago, the Nelson A. Rockefeller Institute of Government said yesterday. Investment losses also left state pensions $500 billion short of funds by mid-2008 to cover benefits, the Pew Center on the States said in June.
Local governments are feeling the strain. Vallejo, California, filed for bankruptcy protection in 2008 and Reading, Pennsylvania, sought refuge in the state’s distressed-municipality program last year.
The Harrisburg Authority in Pennsylvania is the kind of trouble that could derail Ross’s ambition. Assured Guaranty has had to make more than $1 million of missed payments since last year on bonds it insured for the incinerator operator.
That’s the kind of risk that deterred Buffett. Backing tax-exempt bonds “has the look today of a dangerous business,” Buffett wrote to shareholders of Omaha, Nebraska-based Berkshire Hathaway Inc. last year.
No New Issues
Berkshire hasn’t been the primary insurer of a new municipal bond since November 2009, data compiled by Bloomberg show. In 2010 so far, it has insured 19 securities with a face value of $118 million, all in the secondary market, where investors trade bonds among themselves after their initial sale. It backed 210 new and secondary issues in 2009 and 525 in 2008.
Buffett and Ross were left alone in municipals two years ago after MBIA and Ambac, plus Financial Guaranty Insurance Co., the No. 3 company, were stripped of their AAA credit ratings amid losses from insuring mortgage-backed bonds. Those are the same securities that bankrupted Lehman Brothers Holdings Inc. in 2008 and brought the longest economic slump since the 1930s.
Before the implosion, MBIA and Ambac were two of the 20 most-profitable U.S. public companies by net income per worker, data compiled by Bloomberg show. In 2005, the four largest bond insurers, accounting for 98 percent of all municipal coverage, had profit margins of 31 percent to 44 percent.
MBIA, Ambac and Financial Guaranty rejected Buffett’s offer in February 2008 to take over $800 billion of insured bonds in exchange for 150 percent of the premiums. Buffett called the snub “very good news” in his letter to Berkshire shareholders.
“I had severely underpriced our offer,” Buffett said. “Local governments are going to face far tougher fiscal problems in the future.”
Ross remains undeterred. His 16 million shares of Assured Guaranty, worth more than $200 million, are the largest holding of his New York-based WL Ross & Co., according to a second-quarter regulatory filing. Armed with the industry’s last AAA rating from Standard & Poor’s, Ross has set out to restore faith in a business that promised for decades to shield investors from market volatility and then became one of the first casualties of the credit market’s collapse.
“The muni situation, to me, is going to be one where some state or another will come close enough to crisis that it will scare the daylights out of everyone and create a buying opportunity,” Ross said in a June 29 Bloomberg Television interview. He didn’t respond to an e-mail for more comment.
While Buffett’s Berkshire Hathaway has stayed put, Hamilton, Bermuda-based Assured backed every state and local bond that carried insurance in the first half of this year, company filings show.
That’s about $13 billion of face value, according to the documents. At that pace, Assured’s new municipal business this year will shrink 45 percent from the $47 billion of last year.
Industrywide, the portion of new municipal bonds insured fell to 9 percent last year from 57 percent at its peak in 2005, S&P said in a June 24 report on Assured Guaranty.
“Investors and issuers are learning to live without insurance,” S&P’s analysis said.
Assured’s AAA financial-guaranty rating from S&P means a lower-ranked issuer buying its insurance takes on that rating, making its securities more attractive and reducing borrowing costs. That’s becoming less necessary as investors fleeing declining stock markets pour cash into municipals and U.S. Treasuries, pushing tax-exempt yields to record lows.
Moody’s and Fitch Ratings also recalibrated their credit scores this year so the default risk of municipals can be compared with that of corporate bonds. The change resulted in higher grades for many cities and states, lessening their need for insurance.
The shrinkage is showing up in Assured’s earnings. The company reported Aug. 5 that second-quarter operating income soared five-fold from a year earlier to $172 million, thanks mostly to the acquisition of Financial Guaranty Assurance Holdings Ltd. in 2009.
A company measure of new U.S. public-finance coverage, called present value of new business production, dropped 36 percent to $81.4 million as state and local bond issuance fell 24 percent, it said. The portion of the market’s new debt backed by Assured Guaranty remained unchanged at 9 percent.
“Having a monopoly isn’t going to do them any good,” said Gao Liu, who teaches public administration at the University of New Mexico in Albuquerque. “They can charge a high premium, but the market is still decreasing.”
Shares of Assured have tumbled 31 percent in New York Stock Exchange composite trading this year to $15.06 yesterday. The Russell 1000 Financial Services Index is down 6.5 percent in the same period and Berkshire Hathaway B shares have risen 19 percent in New York to $77.90 yesterday.
Assured was able to charge more in the second quarter than it did in 2005 to 2007, when there were seven insurers rated AAA vying for business, Chief Executive Officer Dominic Frederico said on an Aug. 6 conference call.
On a similar call a year earlier, Frederico said he’d welcome competition. That’s unlikely soon, said Larkin at Herbert J. Sims, because new entrants will find it difficult to get AAA ratings.
“Rating agencies blew it on bond-insurance ratings,” he said. “You may never see them assigning AAA ratings to bond insurers again.”
In addition to its AAA financial-guaranty rank from S&P, Assured has retained its investment-grade rating from Moody’s while most competitors lost theirs. Moody’s reduced Assured two levels to Aa2 from Aaa in November 2008, and then one level lower a year later to Aa3, its fourth-highest score.
The reductions shrunk the number of issuers that can benefit from Assured’s insurance and could pressure the company into backing higher-risk debt, said Robert Doty, a municipal finance adviser at American Government Services in Sacramento, California.
Among bonds Assured took on this year were $103.6 million sold Aug. 9 by Miami to finance a parking garage. The city bought insurance after its general-obligation bond rating was cut by both Moody’s and S&P.
The coverage cost about $3 million, said Miami’s chief financial officer, Larry Spring. It also widened Assured’s exposure to the dangers Buffett warned about, Doty said.
“If they do a lot of parking-lot deals,” he said of Miami, Assured is “going to have problems.”