Friday, February 15, 2008


You have to admire Warren Buffett.

He’s offered to relieve the ailing monoline bond insurers of their very best assets, leaving them with all the subprime rubbish that got them into trouble in the first place. It’s a viciously cut-throat offer to a group of crippled opponents, kicking them when they’re down and defenceless.

He cheerfully admits that this is capitalism, red in tooth and claw, at its finest. “I’m not doing this so that St Peter will let me in at the pearly gates. We are doing this to make money,” he said.

And still the market applauds him as a hero – “Buffett to the rescue!” as one Forbes headline put it.

The man has style...

Warren Buffett’s offer to take all the best bits from the monoline insurers is a smart move. He has said his Berkshire Hathaway investment vehicle will put up $5bn to reinsure $800bn worth of municipal bonds currently backed by the monolines. These are bonds largely issued by local government bodies in the States to raise money for public works.

Let’s recap on what’s happened so far. The monolines are big insurers, who basically rent out their AAA-credit ratings to bond issuers who don’t have high credit ratings. In the good old days before subprime, most of their business was taken up with insuring these municipal, or ‘muni’ bonds.

This was all fine. Although many ‘muni’ bond issuers don’t have much of a credit history (and therefore find it difficult to get decent credit ratings themselves) they are ultimately backed by taxpayers, and thus pretty safe bets. Indeed, the historical default rate is less than 1%. So monolines would back the bonds; the muni issuers would benefit from getting the cheaper borrowing rates that come with a AAA-credit rating; and the monolines would get a nice fee.

Monolines: where it all went wrong

If they’d stuck to that nice little arrangement, everything would have been fine. But along came sub-prime securitisation with its promises of tasty fees and lovely, property-backed bonds that surely couldn’t go wrong. The monolines piled in, but in the process, rented out their AAA-credit rating to the wrong people. Sub-prime blew up, leaving the monolines with a pile of liabilities that they now can’t back up.

The big worry has been that the biggest monolines will lose their AAA ratings, with a few agencies already knocking them down a notch. If they lose their ratings, so do all the bonds they backed, which means even more writedowns for anyone holding onto them – like big investment banks, for example.

Where are the munis in all this? Well, they’ve been hit too. But the difference between munis and sub-prime bonds, is that munis are basically AAA debt that just can’t get the rating. Whereas sub-prime was junk pretending to be AAA. So the munis now look cheap. And as we all know, if there’s a man who can’t resist a bargain – particularly in the insurance sector – it’s Warren Buffett.

So now Mr Buffett’s offering to take responsibility for all these low-risk munis ($800bn-worth) off the three biggest monolines’ (Ambac, MBIA and FGIC) hands for the princely sum of $5bn. The deal would free up around $8bn worth of capital for the bond insurers – munis are low risk, but they still have to put aside some money to cover them. That would give them a bit more breathing space in their desperate dash for capital to allow them to hold onto their AAA-ratings.

“This would just eliminate one major cloud from the market,” said Buffett. It’ll also mean a great return for Mr Buffett. The Telegraph reports that if Ambac and MBIA were to accept the deal, Berkshire Hathaway would end up netting $3bn in premiums.

Are the monolines desperate enough to accept?

It’s a smart offer. Of course, that doesn’t mean they’ll accept it. One has already rejected the offer. And the truth is, it does look like the kind of deal you’d only accept if you were absolutely desperate. After all, this boils down to selling your best income-producing assets so that the money can be thrown after your bad loss-making ones.

And JP Morgan estimates that if mortgage defaults continue at the current rate, the bond insurers could be looking at $41bn of losses in all. In that context, $8bn suddenly doesn’t look like much money.

But as Mr Buffett might be thinking, ‘beggars can’t be choosers.’ I suspect the monolines will reject this initial offer. But I wouldn’t be surprised to see a deal hammered out at a later date when things inevitably continue to deteriorate in the US housing market. Eventually Mr Buffett will make them an offer they can’t refuse.

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