Sell Side

Buffett Stays Cautious

Since Warren Buffett's Berkshire Hathaway Assurance Co. entered the bond insurance market, it has limited its production of new business and asked for high premiums.

Last year, it wrapped just 22 issues with a par value of $3.3 billion in the primary market, according to Thomson Reuters.

In his annual letter to Berkshire Hathaway Co. shareholders released this weekend, Buffett explained why the business has stayed small. He wrote that the company remains "very cautious" about the new public finance business it writes and "regard it as far from a sure thing that this insurance will ultimately be profitable."

Buffett's concerns center around the fiscal difficulties he expects for municipal issuers, and the low insurance premiums tax-exempt issuers typically have paid based on the fact the asset class has historically had low default rates. He warned that those default studies are based largely on the experiences of uninsured bonds and that people should be cautious about any "history-based models," noting that is what helped lead to the "stupefying losses in mortgage-related securities."

"Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma, and the like, these models tend to look impressive," Buffett wrote. "Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: beware of geeks bearing formulas."

Local governments will face "far tougher fiscal problems in the future than they have to date," Buffett wrote in his letter. Pension liabilities will continue to put pressure on municipal issuers, many of which were "surely horrified" at the status of their funding levels at the end of 2008, he added.

With regard to defaults, Buffett believes a universe of insured bonds will behave differently than one of uninsured bonds. Issuers with insurance will have less of an incentive to develop solutions favorable to bondholders than those that have uninsured bonds held by local banks and residents, he wrote.

Buffett pointed to the fiscal problems New York City had in 1975, when virtually all of its bonds were uninsured and "heavily held by the city's wealthier residents as well as by New York banks and other institutions."

If New York City's bonds were insured by Berkshire Hathaway, "similar belt-tightening, tax increases, labor concessions, etc.," would not have occurred, Buffett wrote. The insurer would have been expected to " 'share' in the required sacrifice," he said.

In addition, some have argued that municipal issuers will do all they can to avoid defaulting because they don't want to risk losing access to the capital markets. But Buffett said once a few issuers "stiff creditors and get away with it," others will follow. He believes municipal defaults would be highly correlated.

"Insuring tax-exempts, therefore, has the look today of a dangerous business - one with similarities, in fact, to the insuring of natural catastrophes," Buffett wrote. "In both cases, a string of loss-free years can be followed by a devastating experience that more than wipes out earlier profits. We will try, therefore, to proceed carefully in this business, eschewing many classes of bonds that other monolines regularly embrace."

An industry source noted that issuers are obligated to reimburse insurers for any payments they miss. In addition, the severity of an actual municipal default often is small. Also, although bond insurers are highly leveraged, they try to manage their own liquidity risks by limiting the total amount they would pay out in claims in any given year, the source said.

BHAC is typically viewed as the strongest of the existing monolines. On a long-term issue with an A underlying credit, its guarantee trades about 35 basis points better than one from Assured Guaranty Corp. or Financial Security Assurance Inc., Citi managing director and fixed-income strategist George Friedlander wrote in a report last month.

Thanks to a guaranty from affiliate Columbia Insurance Co., BHAC is the only financial guarantor rated Aaa by Moody's Investors Service.

BHAC has taken in $96 million in premiums on the approximately $3.7 billion in primary market insurance it has written so far, Buffett said. Berkshire has been more active in the secondary market, writing about $15.6 billion of insurance.

Of those secondary policies, 77% are already insured, meaning Berkshire only pays if the original - and, in some cases, subsequent - insurer defaults. In one "extreme case," Berkshire would be the fourth insurer to pay on a policy, Buffett said.

Buffett also noted that he lucked out when MBIA Insurance Corp., Ambac Assurance Corp., and Financial Guaranty Insurance Co. turned down his offer in early 2008 to assume their public finance books, a combined $822 billion in bonds. Buffett said he would have charged a rate of 1.5% to take over the guarantees and make Berkshire the first insurer to pay. Berkshire ended up charging insurance rates averaging 3.3% in the secondary market. And with those wraps, it didn't have to pay unless the original monoline couldn't.

"The monolines summarily rejected our offer, in some cases appending an insult or two," Buffett wrote. "In the end, though, that proved to be very good news for us, because it became apparent that I had severely underpriced our offer."


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