Buffett's happy monoline snub
Bond insurers refused the Berkshire Hathaway chief's reinsurance bid - an outcome he now applauds.
NEW YORK (Fortune) -- Sometimes the best deals are the ones you don't get.
At the time, the companies -- known as monolines because in an earlier incarnation they insured only municipal bonds -- were under enormous pressure as investors bet their thin capital bases would be overwhelmed by rising losses on bonds they guaranteed. The problems at Ambac, MBIA and closely held FGIC stemmed in large measure from their decision to expand beyond muni bonds, which historically have suffered few defaults, to the structured investment products peddled with such vigor - and such awful consequences - in recent years by Wall Street.
Observing a panic that had shares in Ambac (ABK) and MBIA (MBI) down more than 80% from peak levels, Buffett spotted an opportunity to take over what looked like a profitable, low-risk business. He offered to take over the companies' municipal portfolios, which contained guarantees on $822 billion of bonds, some running as long as 40 years.
What's more, Buffett wouldn't pay for these portfolios. Instead, he proposed that the companies pay Berkshire a premium of 1.5% of the insured business. In the case of Ambac and MBIA, Buffett said, he'd cover $600 billion of muni contracts, and the companies would pay him $9 billion.
But while the proposal got significant play in the media, it wasn't received well by the bond insurers.
"The monolines summarily rejected our offer, in some cases appending an insult or two," Buffett wrote in his letter to shareholders Saturday. "In the end, though, the turndowns proved to be very good news for us, because it became apparent that I had severely underpriced our offer."
Buffett goes on to say that his own bond insurer, Berkshire Hathaway Assurance Co., or BHAC, ended up writing $15.7 billion worth of bond insurance last year. The lion's share - $12 billion worth -- was on bonds that already had insurance from another carrier.
Remarkably enough, Berkshire ended up charging more than twice as much as Buffett had proposed in his offer to the monolines -- 3.3% on average, he said. On these policies, Berkshire will end up paying claims only if the primary insurer fails.
"We have a great many more multiples of capital behind the insurance we write than does any other monoline," Buffett said. "Consequently, our guarantee is far more valuable than theirs. This explains why many sophisticated investors have bought second-to-pay insurance from us even though they were already insured by another monoline."
But while Berkshire investors can be happy Buffett's underpriced offer failed to win the day, he says the monoline episode pounded home an important point: that municipal bonds may not be as safe as their low recorded loss rates would suggest, particularly in a deep recession.
Buffett said the rationale for the low rates that insurers have charged to cover tax-exempt bonds is that defaults have been rare. But he notes that most tax-exempt bonds over the course of time have been uninsured.
The key point, Buffett says, is that the presence of insurance on a bond is apt to change the behavior of issuers when they run into financial trouble -- and not for the better, as far as bondholders and insurers are concerned.
Buffett notes the example of New York City's brush with bankruptcy in 1975, which he says was averted when stakeholders saw what was at risk in a default.
"At the time its bonds -- virtually all uninsured -- were heavily held by the city's wealthier residents as well as by New York banks and other institutions," Buffett wrote. "These local bondholders deeply desired to solve the city's fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution."
But offered the choice between personal sacrifice and forcing private companies to make good on their promises, Buffett adds, people will obviously take the latter route.
"When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop 'solutions' less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents," he wrote. "What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?"
Buffett's answer is that he hopes not to find out. He told shareholders in Saturday's letter that he plans "to proceed carefully in this business, eschewing many classes of bonds that other monolines regularly embrace."