Buffett’s Warning Of “Dangerous Business” Grips Bond Insurers

Posted By on February 21, 2010

Buffett’s Warning Of “Dangerous Business” Grips Bond Insurers

By Christine Richard and Darrell Preston


Feb. 19 (Bloomberg) — Forewarned bankruptcies linked to infrastructure projects from Las Vegas to Harrisburg, Pennsylvania, may prove Warren Buffett’s conclusion that insuring municipal bonds is a dangerous business.

Ambac Financial Group Inc., the second biggest bond insurer, faces as much as $1.2 billion in claims if a judge in Nevada allows Las Vegas Monorail Co., which runs a train connecting the city’s casinos, to reorganize in Chapter 11 bankruptcy. The City Council of Pennsylvania’s state capital shelved a plan to sell taxpayer-owned assets to meet payments on $288 million of debt used for an incinerator funded in part with bonds insured by a unit of Bermuda-based Assured Guaranty Ltd. Harrisburg is weighing a possible bankruptcy filing.

With state tax collections last year through September showing the biggest drop since at least 1963, as measured by the Nelson A. Rockefeller Institute of Government in Albany, New York, local governments are seeking concessions from creditors of public projects, including bond insurers. The moves further threaten companies backing $1.16 trillion of public debt that already face $11.6 billion of claims on collapsed securities backed by mortgages.

“It is a worst-case scenario if the dynamics of the municipal bond market change, said Rob Haines, an analyst who covers the bond insurance business at CreditSights Inc., an independent research firm in New York. The companies have modeled in virtually no losses.

Local governments are struggling with depressed property values and sales, 9.7 percent unemployment and a slowdown in consumer spending that has cut tax revenue.

Last year, 183 tax-exempt issuers defaulted on $6.35 billion of securities, according to Miami Lakes, Florida-based Distressed Debt Securities Newsletter. That’s up from 2008, when 162 municipal borrowers failed to meet obligations on $8.15 billion of debt. In 2007, 31 of them defaulted on $348 million of bonds.

“In the past, things had a way of getting worked out,said Jim Ryan, an insurance analyst with Morningstar Inc. in Chicago. States might have stepped up and helped out, but bottom line is that the states are in trouble.

Ambac sold the industry’s first insurance policy on municipal debt in 1971, for a $650,000 bond of the Greater Juneau Borough Medical Arts Building in Alaska. The business thrived, with a handful of companies obtaining the top AAA credit rating needed to guarantee debt of state and local governments and their agencies that seldom defaulted. About 8.5 percent of the market for new municipal debt was insured in 2009, down from 55 percent in 2005, according to Thomson Reuters.

For more than three decades bond insurers paid few claims, allowing them to back bond payments that were 140 times their assets. Insurers described their business as one of zero-loss underwriting, meaning that each guarantee was expected to result in no claims under the worst probable scenario envisioned by their models.

That track record was shattered when credit markets seized up during the worst credit crunch since the Great Depression. After rating companies warned they might strip bond insurers of their top rankings in late 2007, some companies averted a takeover by regulators by tearing up contracts on their worst- performing structured finance securities and freeing up reserves against those contracts.

Rising municipal claims may deplete the remaining regulatory capital of some bond insurers and speed intervention by regulators, said Haines of CreditSights.

Any regulatory takeover may trigger termination payments on billions of dollars of credit default contracts written by the bond insurers, a scenario that forced a government bailout of American International Group Inc. in September 2008.

Battles over debt payments were anticipated by Buffett, chairman of Berkshire Hathaway Inc. The billionaire investor set up a municipal bond insurance company in December 2007, as competitors were being threatened with the loss of their top ratings.

In early 2008, Omaha, Nebraska-based Berkshire Hathaway’s bid to take over $800 billion in municipal debt guarantees from the three biggest bond insurers, including Ambac, was rejected by the companies.

A year later, he reversed course, telling shareholders in his annual letter that municipal bond insurance has the look today of a dangerous business.

“If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow, Buffett 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?

“One of the unspoken benefits the bond insurers provided to the municipal bond market was access to capital to refinance bond issues that were threatening to default, Ciccarone said.

That strategy isn’t being used now.

Last Updated: February 19, 2010 16:35 EST


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