Thursday, February 21, 2008

Buffett's Bargain

"Municipal bonds seldom if ever default. ... Let's pause, however, to consider how some crazy rules helped inadvertently bring [Warren Buffett] his present opportunity--and put the world seemingly on the brink of financial chaos. In the abstract, of course, neither bond insurance nor bond raters should exist. The market ought to be able to assess and price bond issues efficiently itself, leaving no profit opportunity for raters and insurers. ... In effect, a triple-A insurer turns every bond issuer into a triple-A issuer, and does it more cheaply than the bond issuer could do it for himself. ... Hooray for an efficient market solution. Or it would be an efficient market solution if participation by all parties were voluntary, therefore conditoned by appropriate skepticism. ... We're not so sure the result [downgrades of thousands of municipal bonds] would be the financial catastrophe that some forecast. The market might well recognize the value of the downgraded bonds despite any downgrades. ... Enter Mr. Buffett, who offers to solve the problem is his own way, no doubt hoping regulators will quietly pressure the big bond insurers to acquiesce in his proposal to take their bread-and-butter business away from them, leaving them to sink into the mire along with their remaining subprime bets. ... We should quickly note that he's not offering to solve the problem for many banks that own mortgage-backed securities also insured by the bond insurers--but these banks have already shown themselves capable of facing up to their losses", Holman Jenkins (HJ) at the WSJ, 13 February 2008.

Buffett's "offer yesterday to wade into the bond-insurance market was only half-brave, so its worth paying attention to where he thinks the risks lie. ... The argument goes that if the bond insurers are downgraded across the board, the bonds they've insured go south too, causing writeoffs and another cascade of financial-industry losses. ... But the notion that a spare billion or two for the 'monolines' could forestall many billions more in writedowns never made any sense. ... That's why the calculating Mr. Buffett only wants to reinsure the municipal business, which is pretty much all premiums and no claims. ... And a few billion dollars in capital won't be nearly enough to make a dent in the $1 trillion in exposure that the bond insurers have to the asset-backed market", my emphasis , Editorial at the WSJ, 13 February 2008.

"More fundamentally, however, Buffett's bid should remind us that most municipal bonds don't need insurance at all. They haven't been very risky. After studying the history of bond defaults, a research firm called Municipal Market Advisors found that only 2.65% of munis rated Ba or better by Moody's had defaulted, compared with 19.12% of similarly rated corporate bonds. [S&P's] discrepancy was even greater: 1.74% of municipals rated double-B or better defaulted compared with 29.93% of like-rated corporates. ... The muni-rating scale increases taxpayers' cost of borrowing, and it has lined the pockets of municipal-bond insurers. The [SEC], which handed the rating agencies far too much power, should stop this long-running scam, not let Buffett join the feast", my emphasis, Thomas Donlan (TD) at Barron's, 18 February 2008.

I agree with HJ, the monolines' end will not be the catastrophe many believe it will be. I think the market already prices bonds as if the monolines don't exist. See my 16 February 2008 post.

I never saw any value provided by the monolines in their muni business since it: "is pretty much all premiums and no claims". If so, who needed them? Consider, a municipality wants to sell a bond. How is the bond buyer's position improved by paying a monoline a premium in excess of the expected value of its default rate? We have a "fallacy of composition", all municipalities are weakened by the premiums they pay to the detriment of muni bond holders. The muni bond holders could more cheaply "self-insure" by buying a muni bond fund. TD says it all: muni bond insurance is a "scam". It's time it ended

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