Behind Buffett's Bond Gambit
The role of the white knight who swoops in to rescue a business in distress is one that Warren Buffett plays well, and he's profited nicely from it in the past. Remember his bailout of Salomon Brothers in the early 1990s? But the financial guaranty outfits whose municipal-bond liabilities the billionaire investor offered to take over last week may not wish to take part in Buffett's latest performance.
In an interview on CNBC Business News on Feb. 12, Buffett said that in the prior week his company Berkshire Hathaway (BRKA) had offered to reinsure about $800 billion worth of tax-exempt municipal bonds insured by three leading financial guaranty firms, which would allow them to preserve their coveted triple-A ratings. He would also put $5 billion of capital into his new bond insurance company, Berkshire Hathaway Assurance, to provide it with the wherewithal to cover the assumed liabilities.
At-Risk Insurers Might Say No
Buffett's move comes at a particularly anxious time for the bond insurance industry. The three companies to whom Buffett made the offer—MBIA (MBI), Ambac Financial Group (ABK), and privately held Financial Guaranty Insurance (FGIC)—have been doggedly trying to secure capital infusions from investment banks, private equity firms, and other sources, to help them preserve their triple-A ratings, a requirement if they hope to attract new business. The insurers face the prospect of going under if they can't raise ample cash to cover all the claims that would result if the asset-backed securities that they have insured—including collateralized debt obligations—should default.
Shares of MBIA and Ambac fell more than 15% on Feb. 12.
Buffett is giving the bond insurers 30 days to shop around for a better offer, but he told CNBC that one of the companies has already rejected his bid.
Market observers presume that MBIA has already turned down Buffett's offer, as the company has a commitment from Warburg Pincus to buy $1 billion in convertible preferred stock and last week issued $1 billion in new common stock.
And MBIA may not be the only one to rebuff Buffett. "I'm not sure any of them will take this offer because it's not clear to me that it's that beneficial either from a rating agency perspective and certainly from a financial perspective," says Gary Ransom, an equity analyst at Fox-Pitt Kelton in West Hartford, Conn. "The scales are tipped steeply toward Buffett," he says. (Fox-Pitt or its affiliates may seek compensation for investment banking services from Berkshire Hathaway during the next three months.)
Buffett Presses His Advantage
The reason for going public with his offer was probably the hope of getting the ratings agencies and regulators to put pressure on the bond insurers to accept the deal, says Whitney Tilson, managing partner at T2 Partners, a hedge fund manager in New York.
Buffett has made it very clear that there's nothing altruistic about his offer. He stands to make a lot of money by assuming these policies, given that the cities and towns that issue munis hardly ever default on their debt. When they do, the recovery rate is more than 90%, compared with a 50% recovery rate in corporate debt defaults, says Tilson.
Buffett has long had his eye on the muni-bond insurance business and in December announced he was starting Berkshire Hathaway Assurance.
"It's certainly an easy way to scale up the business quickly by buying books of insurance policies from the three largest players," says Tilson.
Buffett's opportunism could pay big dividends. If it's successful in taking over the liabilities of MBIA, Ambac, and FGIC, Berkshire Hathaway Assurance would be well on its way to becoming the only game in town, said Mark Hirschey, the Anderson W. Chandler Professor of Business at the University of Kansas.
"If you're a new issuer of municipal bonds, you're not going to Ambac or MBIA or anyone else. You're going to Berkshire Hathaway," he said. "Its offer to take $800 billion in assets is an attempt to extend their advantage in writing new business to taking some of the booked business that the industry already has."
Market participants said they don't believe Buffett's offer is in any way motivated by concerns about protecting his broader financial holdings. "His portfolio is in very safe short-term Treasurys. He's extremely well positioned," said Tilson.
In his interview on CNBC on the morning of Feb. 12, Buffett said he was offering better-than-market terms by asking the bond insurers to pay him 1.5 times their unearned premium reserves, when he typically gets paid twice the original insurance premium to reinsure muni bonds, Tilson said.
As of Dec. 31, the unearned premium at MBIA alone was $6 billion, which included deferred premium revenue of $3.1 billion, Hirschey said.
But for MBIA and Ambac, it's not their muni-bond business that's in trouble—it's their structured finance business. And that's all they would be left with if they were to accept Buffett's offer.
"This is a sensible offer, but probably not the best offer from the bond insurers' standpoint," said Tom Kersting, an equity analyst at Edward Jones in St. Louis.
Insurers Look to Banks and the Fed
The bond insurers haven't exhausted their options yet. There's still a chance that banks with exposure to credit default swaps will come through with a bailout plan, and regulators are interested in propping up these insurers, if only to avoid a bigger threat to the entire financial system by risking the wholesale downgrade of more than $2 trillion in muni bonds, said Kersting.
Companies such as Merrill Lynch (MER) and Citigroup (C) have a big incentive to work with the bond insurers. But given that they're facing huge losses themselves for their structured finance exposure, they are not in a position to be of much help. State regulators such as those in New York and Wisconsin don't have the financial muscle to shore up the bond insurers either, but the Federal Reserve has said it would use all the tools at its disposal to avoid a financial crisis.
There may be another reinsurer that could make the bond insurers a better offer, but there aren't many that would be able to backstop it with $5 billion of capital, as Buffett is willing to do, Tilson said.
And that may leave Buffett as the last best hope for battered bond insurers.