Sell Side

The CDS Strategy

Berkshire Hathaway Assurance Corp., the newest bond insurer in the municipal bond market, was also the highest-earning of its peers in the first quarter, using a strategy of writing credit default swap contracts to provide secondary market insurance, earning about $300 million in premiums in the quarter.

BHAC's parent, Berkshire Hathaway Inc., said in first-quarter financial statements that BHAC had earned about $400 million in total premiums during the quarter. The total was notable for its size, as BHAC was formed in December and spent much of the quarter getting licenses from state insurance departments and ratings from the rating agencies.

On Feb. 21, Moody's Investors Service assigned a Aaa rating to the new bond insurer for secondary market insurance. Both Moody's and Standard & Poor's have since given BHAC triple-A ratings for primary market insurance.

According to the first quarter statement, BHAC earned about $100 million in new premiums on 278 insurance policies in the quarter. Berkshire Hathaway Reinsurance Group, the umbrella under which BHAC falls, received about $300 million for transactions structured as CDS contracts.

The CDS contracts were structured through a separate entity called BH Finance LLC, according to CreditSights analyst Rob Haines, who wrote a research note about BHAC after speaking with company executives. The agreements provide credit protection on municipal bonds in the secondary market.

The BHAC premiums for the quarter are more than twice the $196.6 million earned by Financial Security Assurance Inc., one of only two other bond insurers to be rated triple-A with a stable outlook, and the market leader.

Berkshire is not the only financial guaranty company to use CDS contracts to provide secondary market insurance on bonds already wrapped by an insurer. Assured Guaranty Corp., Radian Asset Assurance, XL Capital Assurance, and others have also structured insurance policies in this way.

"When these CDS get written, they look like insurance," said Peter Bianchini, former managing director at XLCA. "The CDS policies had the same characteristics - they couldn't be accelerated and they couldn't be terminated. So they look and felt like insurance, but they were technically credit default swaps."

Regardless, the disclosure that BHAC is employing derivatives comes as surprise. In the 2002 Berkshire Hathaway annual report, Warren Buffett said "derivatives are financial weapons of mass destruction." He has also been outspoken about the failings of the other bond insurers for expanding their business into other, riskier markets, which they did through writing CDS contracts on collateralized debt obligations, among other efforts.

In the 2007 annual report, Buffett wrote that Berkshire Hathaway had 94 derivative contracts that he manages.

Ajit Jain of Berkshire Hathaway Assurance did not return a call for comment.

To be sure, the CDS contracts written for municipal bonds in the secondary market are not the same as those written on securities tainted by sub-prime mortgages. They are written on municipal bonds with historically low default rates and an insurance policy from another financial guarantor. But the rules that regulate CDS require mark-to-market accounting, which can introduce volatility in the values of the instruments.

As a result, many insurers try to stay away from writing secondary market insurance in CDS form, choosing instead to write it as a financial guaranty policies. Both Assured Guaranty Corp. and FSA, Berkshire's stable, triple-A rated competitors, completed many secondary market deals in the first quarter but none of them took the form of CDS contracts.

"Our practice has been to use financial guaranty policies rather than CDS to provide secondary insurance in the U. S. public finance market," said FSA chief executive officer Robert Cochran.

Other insurers, with their own risk profiles, have also stayed away from or stopped writing CDS contracts as a way to reduce the volatility on their own books. Despite being quick to point out that mark-to-market calculations are not indicative of actual losses because they hold the CDS to maturity, bond insurers said they were adverse to bringing that volatility onto their balance sheets, especially in the current environment.

"We prefer to write financial guarantys because CDS get marked to market and that's what generates those balance sheet unrealized losses," said Sabra Purtill, head of investor relations at Assured Guaranty Ltd., parent of the bond insurer.

If the cost of insurance and the price of the CDS falls, the credit default contracts would show a big gain. On the other hand, if the issuer is downgraded, it could cause the CDS contract to show a loss, even if it was a highly rated stable general obligation credit.

"A CDS that has a solid investment grade issuer and an insurer in front of it is going to price differently than one that has a weak issuer and an insurance company that has been downgraded or looks less credit worthy," Bianchini said.

With such volatility, insurers said they would not like to write the secondary market insurance as a CDS contract, unless it was preferred by clients. In many cases, municipal bond investors are ambivalent about whether the secondary market insurance is in financial guaranty policy or CDS form. But banks prefer CDS because they can be used to hedge other muni positions, sources said.

"The only reason why we would [do a secondary CDS contract] is if the counterparty preferred that form of execution," said John DeLuca, a senior vice president and director of marketing at Radian Asset Assurance. "It is typically bank trading desks that have a position on the other side that they need to balance with a CDS."

And banks cannot use the alternative, financial guaranty policies, as a similar hedge.

"Financial guaranty policies don't count as hedging purposes for banks accounting, they would need a derivative," Purtill said.

Sources said it is likely that the majority of the secondary market insurance written by Berkshire, at least in CDS form, was sold to banks with municipal bonds in their portfolio that were previously insured by downgraded companies. One person said Deutsche Bank AG and Goldman, Sachs, among others, would be the type of banks to use CDS for this purpose. The first secondary market policy sold by Berkshire was on a block of bonds for Goldman.

In recent weeks, the New York State insurance superintendent Eric Dinallo has taken a more active role in evaluating the use of CDS contracts among the financial guaranty insurers. Dinallo wants to start a discussion to bring the regulation of certain CDS contracts under the umbrella of insurance officials.

In cases where CDS are tied to a specific bond for the purposes of providing protection against the default of that bond - like those most used by the bond insurers - the contract functions like an insurance policy, said a spokesperson for the department. It is these CDS, as opposed to those used for speculation, that could fall under insurance department regulations.

"Effectively our goal is to start a conversation," the spokesman said.

The latest efforts from Dinallo fall under the department's three-part plan for the financial guarantors unveiled in January. One of his ideas for addressing the current troubles is looking into stronger regulation for bond insurance and under such an effort, Dinallo could place limits on the use of CDS by financial guarantors.



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