Why insurers are rebuffing Buffett
Berkshire Hathaway's offer to the troubled bond insurers is presented as a rescue, but its terms may be too tough for the companies' shareholders to accept.
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NEW YORK (Fortune) -- Berkshire Hathaway's latest foray into bond insurance is classic Warren Buffett. The Omaha billionaire has floated a proposal that is highly favorable to him and his shareholders - and excruciatingly tough on the companies he is targeting. But while the proposal has been widely described as a rescue, there are signs that Buffett's prey - including publicly traded Ambac and MBIA - aren't yet desperate enough to take the deal.
On Tuesday, Berkshire released a letter it sent to three bond insurers - understood to be Ambac, MBIA and closely held FGIC - offering to take over their municipal insurance obligations. Berkshire says the deal will allow the companies to focus on their other businesses, including the credit derivatives portfolios that have put the insurers under the close scrutiny of the ratings agencies.
Under the deal, Berkshire would take in $6 billion worth of so-called unearned premiums - money the insurers have collected from municipal policyholders but haven't recognized as revenue or paid in claims - plus a $3 billion fee. In essence, Berkshire is asking for a premium payment equal to 150% of unearned premium reserves - a price that Berkshire reinsurance chief Ajit Jain acknowledges, in a letter to one insurer, could appear to be "excessive."
But Jain goes on to argue that with the bond insurers scrambling to hold onto their triple-A ratings, even an expensive deal with Berkshire is well worth their while. "I would submit that our proposal at the pricing levels we require is actually a cheap way for MBIA to raise capital as compared to other alternatives," Jain wrote in a letter last week to MBIA banker Lazard, "and is therefore of great benefit to MBIA's owners and their municipal policyholders."
So far, though, MBIA's owners aren't seeing the benefit. Shares of the company slid 11% in early afternoon trading, and investors said they're skeptical that MBIA or Ambac would agree to the terms Buffett laid out. Buffett's letter says Berkshire approached three insurers and has been turned down by one. As of this morning, Berkshire says it hadn't heard from the other two.
Rob Haines, who covers the insurance industry for independent research shop CreditSights, says he believes MBIA (MBI) - which has raised more than $2 billion this year in new capital - is the one that turned Buffett down. "MBIA is trying to position itself as a survivor," Haines says, "so I can't see them as attracted to this." Calls to MBIA, Ambac and FGIC weren't immediately returned. Lazard had no comment. On Tuesday after market close, Ambac issued a staetment indicating that it would seek another route.
But Haines and others doubt the monolines will be willing to give up the one business they have that is doing well. "Doing this deal would be a clear white flag that [the monoline insurers] are entering run-off," adds Haines, referring to the state in which insurers stop writing new policies. Given the steep declines in values of so-called structured credit products, the muni business is "their only real franchise remaining," says Haines.
Other investors who follow the monolines shrugged off Buffett's offer as well. The proposal "is not a great surprise," says Andrew Moloff, chief investment officer at Ambac shareholder Evercore Asset Management in New York. Evercore last month sent a letter to Ambac urging the company not to dilute current shareholders by selling stock at depressed prices to raise capital in a bid to hold onto its triple-A credit rating. Talks between the insurers and Buffett have been reported over the past few months, but no transaction has taken place because Buffett "wants a very high price" for a deal that the monolines would probably prefer not to do, Moloff says.
Moloff notes that Buffett likes the municipal bond business because it is profitable and bears little risk of default. A reinsurance deal thus appeals to Buffett - but presumably not to managers of Ambac (ABK) and MBIA, because it would effectively strip the insurers of their best business and leave them with fewer resources to deal with possible losses on their risky credit derivatives portfolios.
CreditSights' Haines takes issue with Buffett's argument that the deal would free up capital held against the monolines' massive municipal obligations. In terms of insured deals, "Ambac has $300 billion alone as of Sept. 30," he notes. "Munis don't require a lot of capital to be held in reserve," he adds, "so the loss of that earnings stream would hurt capital in the short-term."
But Whitney Tilson, a partner at investment management firm T2 Advisors who is short MBIA and Ambac (betting on their shares' decline) believes Buffett is "playing to a larger audience." He believes regulators are eager to prevent widespread downgrades of municipal bonds, which could saddle municipalities with higher interest costs and lead down the road to higher taxes. He calls Buffett's proposal "potentially great for the markets and the financial system," because real risks and liabilities would be covered by Berkshire (BRKA, Fortune 500), whose triple-A credit rating - in contrast to Ambac and MBIA - is not under review. He adds, speaking of MBIA and Ambac, "This is just as obviously terrible for their shareholders."
And of course, that's the beauty of the deal - if it happens - for Buffett: Anything that's bad for one set of shareholders is likely to be good for another. "You can bet that Warren can meet his return-on-equity target with this deal," says David Merkel, chief economist and director of research at broker-dealer Finacorp Securities. Referring to Buffett's refusal to pursue deals that might dent Berkshire's profitability, Merkel added: "He never pays up."