Buffett's Letter on Muni Insurance; Berkshire Insured Detroit Revenue Bonds After FGIC

BHAC/FGIC Collaboration (MSRB)
After a post I did a few days ago on Detroit's 2011-12 budget, I found out that Berkshire Hathaway's AAA rated subsidiary, Berkshire Hathaway Assurance Corporation, insured $767 million Detroit revenue bonds on a second-to-pay basis. These bonds were re-marketed and converted into fixed rates in 2008. Berkshire insured $385 million Detroit water revenue bonds (official statement at msrb.org) and $382 million Detroit sewage disposal revenue bonds, but only if bond insurer FGIC failed to pay. Principal and interest payments are backed "solely" by net revenues of pledged assets (water and sewage funds), not by taxes like general obligation bonds.

At that time the large muni bond insurers, Ambac, MBIA and FGIC, were being downgraded as losses mounted on toxic credits they insured (MBS). As a result, Buffett wanted to leverage his AAA rating and grab share in the muni insurance market. Issuers wanted Berkshire's guarantee because it lowered interest payments. Berkshire eventually "pulled out of municipal bond insurance" when he thought he wasn't being compensated for the risk (GuruFocus). Read Buffett's 2008 investment letter below for more details. It is interesting that Financial Guaranty Insurance Co.'s parent company, FGIC Corp., filed for bankruptcy in August 2010 and its insurance company had its muni bond insurance reinsured by a division of MBIA in early 2009. Counterparties squared.

"The majority of FGIC Co.-insured bonds were reinsured in January 2009 by National Public Finance Guarantee Corp., the investment-grade, muni-only insurer owned by MBIA Inc." (Bond Buyer)

From Bloomberg on May 1, 2008 on the Detroit bond deal:

"May 1 (Bloomberg) -- Detroit sold about $383 million of bonds carrying insurance from Berkshire Hathaway Assurance Corp., marking the first foray by Warren Buffett's four-month- old guarantor into the primary market for U.S. municipal debt."

"Detroit sold Berkshire-backed bonds at yields ranging from 2 percent on debt due in July to 4.75 percent on bonds set to mature in 2027. The largest single series of bonds -- $136 million of debt paying a 5.75 percent rate and due in 2031 -- were priced to yield 4.67 percent, 13 basis points less than Municipal Market Advisors' index of top-rated debt at similar maturities. A basis point is 0.01 percentage point."

More information from The Bond Buyer (4/30/2008):

"As the finance team crafted the transaction, they met with several monoline bond insurers with the hope of leaving the FGIC policy in place and bringing in a secondary insurer for additional protection. Officials considered Financial Security Assurance - which insures a remaining piece of the water and sewer bonds - but the insurer backed off because of its heavy coverage of much of the city's outstanding debt.

Only Berkshire Hathaway was interested in acting as a secondary insurer with FGIC, according to a source. "They didn't have the same idea about FGIC being in place on the bonds as the other insurers had," he said. "The Berkshire insurance really gilds the lily [on the bonds]." It will mark the first time that BHAC will act as insurer on a primary market transaction, officials said."

Credit ratings in the news:
Fitch Drops $4.6 Billion of Detroit Water and Sewer Bonds (BondBuyer, April 1, 2011)
Detroit Water and Sewer Revenue Bonds Are Downgraded by Moody’s (BusinessWeek, December 20, 2010)

Since Berkshire Hathaway was directly involved in analyzing municipal credits before the market and economy collapsed in 2008, Warren Buffett is probably a decent source for analyzing municipal credit risk. In Buffett's 2008 letter, he warned about the potential risks involved in insuring muni credits. Read the full portion about tax-exempt bond insurance after the jump.

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

In June of 2009, during a Financial Crisis Inquiry Commission (FCIC) hearing on credit rating agencies, Warren Buffett gave his opinion on the municipal bond market.

"How would I rate the States and major municipalities. I mean if the Government will step in to help them they're triple A. If the Federal Government won't step in to help them, who knows what they are. I don't know how I would rate those myself now, in other words because it's a bet on how the Government will act over time" (quote from CSPAN video via blog post)

Here are Buffett's thoughts on insuring municipal bonds from his 2008 letter to investors.

"Tax-Exempt Bond Insurance

Early in 2008, we activated Berkshire Hathaway Assurance Company (“BHAC”) as an insurer of the tax-exempt bonds issued by states, cities and other local entities. BHAC insures these securities for issuers both at the time their bonds are sold to the public (primary transactions) and later, when the bonds are already owned by investors (secondary transactions)."

"Thereafter, we wrote about $15.6 billion of insurance in the secondary market. And here’s the punch line: About 77% of this business was on bonds that were already insured, largely by the three aforementioned monolines. In these agreements, we have to pay for defaults only if the original insurer is financially unable to do so.

We wrote this “second-to-pay” insurance for rates averaging 3.3%. That’s right; we have been paid far more for becoming the second to pay than the 1.5% we would have earlier charged to be the first to pay. In one extreme case, we actually agreed to be fourth to pay, nonetheless receiving about three times the 1% premium charged by the monoline that remains first to pay. In other words, three other monolines have to first go broke before we need to write a check.

Two of the three monolines to which we made our initial bulk offer later raised substantial capital. This, of course, directly helps us, since it makes it less likely that we will have to pay, at least in the near term, any claims on our second-to-pay insurance because these two monolines fail. In addition to our book of secondary business, we have also written $3.7 billion of primary business for a premium of $96 million. In primary business, of course, we are first to pay if the issuer gets in trouble.

We have a great many more multiples of capital behind the insurance we write than does any other monoline. 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. BHAC has become not only the insurer of preference, but in many cases the sole insurer acceptable to bondholders.

Nevertheless, we remain very cautious about the business we write and regard it as far from a sure thing that this insurance will ultimately be profitable for us. The reason is simple, though I have never seen even a passing reference to it by any financial analyst, rating agency or monoline CEO.

The rationale behind very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely reflects the experience of entities that issued uninsured bonds. Insurance of tax-exempt bonds didn’t exist before 1971, and even after that most bonds remained uninsured.

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. 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. 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. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belttightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Local governments are going to face far tougher fiscal problems in the future than they have to date. The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at yearend 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering.

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. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. 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?

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

* * * * * * * * * * * *

The type of fallacy involved in projecting loss experience from a universe of non-insured bonds onto a deceptively-similar universe in which many bonds are insured pops up in other areas of finance. “Back-tested” models of many kinds are susceptible to this sort of error. Nevertheless, they are frequently touted in financial markets as guides to future action. (If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.)

Indeed, the stupefying losses in mortgage-related securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford. In short, universe “past” and universe “current” had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact.

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

Articles and Information Sources:

April 14, 2008: S&P Rates Berkshire Hathaway Assurance ‘AAA’; Outlook Stable (Insurance Journal)

March, 2008: Ajit Jain's testimony before Congressman Frank, Congressman Bachus, and members of the Committee, on entering the muni bond insurance market (http://www.berkshirehathaway.com/ajit0308dc.pdf)

April 30, 2008: Detroit to Restructure $800 Million (BondBuyer)

May 1, 2008: Detroit Sells Berkshire-Backed Bonds as Investors Seek AAAs (Bloomberg)

Berkshire Hathaway 2008 Year End Investment Letter by Warren Buffett (released in February 2009) (BerkshireHathaway)

October 5, 2009: Berkshire Hathaway Pulls Out Of Municipal Bond Insurance (GuruFocus)

June 2, 2010: Buffett Expects ‘Terrible Problem’ for Municipal Debt (BusinessWeek)

June 23, 2010: Warren Buffett Testifies About Moody's, Warns About Municipal Bonds, Einhorn Says Shut Down Ratings Agencies (MCO) (DistressedVolatility)

August 10, 2010: FGIC Corp. Files for Chapter 11 (Bond Buyer)

April 1, 2011: Fitch Drops $4.6 Billion of Detroit Water and Sewer Bonds (BondBuyer)