Invested or Induced?
by Rob Kirby, Kirby Analytics. December 31, 2006
Since this is New Year's Eve, let's all hoist one for the Oracle of Omaha – shall we? On Friday the Oracle's Berkshire Hathaway announced it was purchasing the reinsurance unit of ING [NRG] for 435.7 million in cash and also notified the free world that it expected to be granted a license Monday [today] to open a new bond insurance business – Berkshire Hathaway Assurance Corporation.
Maybe it’s just me but doesn't this announcement – coming on a Friday with the expected granting of a license by regulators on Monday reek of shotgun marriage?
The folks over at the Financial Times seem to think so:
Bond insurers feel heat as Buffett enters sector
By Andrea Felsted in London and Aline van Duyn in New York
Published: December 28 2007 10:25
Berkshire Hathaway Assurance Corporation [BHAC], as first reported by the Wall Street Journal, will guarantee the bonds that cities, counties and states use to finance public infrastructure projects. The group will also look for opportunities to offer re-insurance to other insurers of municipal bonds.
BHAC hopes to win a triple-A credit rating and has pledged to maintain a capital ratio stronger than its rivals. It plans to charge fees that reflect its financial strength and to avoid insuring structured products, including bonds backed by assets such as mortgages.
If MBIA and Ambac were to lose their triple-A ratings, it would send shock waves through the financial system, as many of the bonds they guarantee are owned by banks and other financial institutions.
Fitch has given MBIA and Ambac about four weeks each to raise $1bn in extra capital or risk losing their triple-A ratings.
The New York State Insurance Department has fast-tracked BHAC's application, to facilitate the entry of a new player.
So who just who are these companies MBIA and Ambac anyway – and why exactly is it so important that the establishment of a better capitalized, Buffett led replacement be expedited?
MBIA and Ambac [along with FSI and FGIC] are integral parts of a clique of monoline bond insurers affectionately known as "the BIG 4".
Recent Developments Further Muddied Already Murky Waters
Recently, the rapidly deteriorating financial condition of ACA Financial Guaranty Corporation [largely brought about due to exposure to Credit Default Swaps entered into with Canadain Bank CIBC] led ratings agency S & P to downgrade ACA's credit rating from investment grade [A] to non-investment grade or "junk status" [CCC].
This becomes problematic because ACA Capital Holdings Inc. also provides financial guaranty insurance [bond insurance] on municipal obligations, asset-backed and corporate financings, bank certificates of deposit and surety risks through its insurance subsidiary.
So the downgrading of ACA means that the insurance given to municipal bonds and derivatives is also downgraded. This amounts to a downgrading the assets themselves because these assets are typically rated the same as their underlying insurer.
The Repeal of the Glass – Steagall Act
As the example above highlights, downgrades in modern debt based systems can and often do have systemic consequences.
Historically [post 1929 – 1999], regulatory statutes like the Glass-Steagall Act of 1933 separated [silo] banking activities according to their business [commercial and investment banking versus, say, insurance].
The silo-ing of these traditional financial activities was intended to serve as nature fire-breaks or safe-guards to systemic events.
This act was repealed in 1999, largely at the behest of former Fed Reserve Chairman Sir Alan Greenspan who was a champion of increasingly blurred lines between traditional lines of financing activities through the meteoric adoption of derivatives and structured finance which the "Black Knight" frequently argued [circa 2004] provided "flexibility",
"Deregulation and the newer information technologies have joined, in the United States and elsewhere, to advance financial flexibility, which in the end may be the most important contributor to the evident significant gains in economic stability over the past two decades...
Financial derivatives, more generally, have grown throughout the world at a phenomenal rate of 17 percent per year over the past decade..."
Make no mistake – today's sub-prime / CDO / ABCP / SIV etc., etc. debacle is a derivatives induced event – a direct descendant of Sir Alan of Magoo's attempts to repeal the business cycle [this same ludicrous flight to flexibility that is now being piloted by "helicopter" Ben Bernanke].
Now Back to the Future
The ramifications of the downgrade of ACA were not lost on some of ACA's largest customers [Merrill Lynch and Bear Stearns] who tried in vain to postpone S & P's downgrade by proposing a rescue [recapitalization] package prior to the downgrade:
Merrill Lynch, Bear Stearns in talks to rescue ACA Capital, New York Times says
December 19, 2007
Bear Stearns and Merrill Lynch are among several major banks in talks to bail out ACA Capital Holdings, a bond insurance company that has guaranteed $26 billion in mortgage securities, the New York Times reported, citing two people familiar with the situation.
If ACA Capital's financial guarantor subsidiary loses its A rating, the banks that insured securities with it would have to take back billions in losses from ACA as part of their credit protection agreement, the Times said.
Had S & P only downgraded ACA we probably wouldn't be having this discussion right now.
But we are having this discussion now.
S & P did not only downgrade ACA.
Perhaps feeling a little bit "snake bitten" with their negligent failure to adequately / prudently rate most of the securitized sub-prime mortgage paper that got the ball rolling in the first place; having "found religion", they went on to place AAA rated Financial Guaranty Insurance Co. [FGIC] on negative credit watch meaning there is a 1 in 2 chance of a rating downgrade in the next 13 weeks.
They also placed Ambac, MBIA and XL Capital Assurance on a negative outlook. This means the chances of a downgrade in the next 24 months is 1 in 3.
So there you have it folks, three quarters of the "Big 4" are all facing downgrades. If they are downgraded, so are the ratings on the outstanding CDS [Credit Default Swaps] and Muni Bonds issued by local governments that they insured; but perhaps more importantly, that means higher yields on Muni debt issues going forward.
So how big is the Muni Bond Market you might ask?
How big is the market?
The municipal bond market is one of the world's largest and most remarkable securities markets. Approximately $1.7 trillion worth of municipal bonds are currently in the hands of investors. There are more than 50,000 state and local entities which issue municipal securities, and 2 million separate bond issues outstanding...
Municipal bonds historically have been an exceptionally safe and tax-favored investment. And they're even more attractive when they're insured, that is, when scheduled interest and principal payments are guaranteed by Triple-A rated municipal bond insurers.
Municipal bond insurance protects investors primarily in two ways. Occasionally, cities or states that issue debt securities get into financial difficulty. When that happens, they may not be able to pay interest and principal on their debt as scheduled. Even if an issuer does not default, the rating agencies may lower the ratings on an issuer's securities if its financial condition deteriorates, causing the market value of its securities to decline.
Investors in bonds insured by Triple-A rated municipal bond insurers are insulated from these risks because they can depend on the insurer, whose claims-paying ability is rated Triple-A, to make timely payment of scheduled principal and interest.
The strong demand for insured issues (almost half of all new issues are insured) is due to investors' desire for secure investments. In addition, when an issuer faces financial difficulties, history has shown that its insured bonds have more liquidity and price protection than its uninsured bonds. Issuers often prefer to offer their bonds with the highest ratings in order to lower borrowing costs...
Higher rates [or even wider credit spreads] in an already slowing economy would be, shall we say, toxic. What's worse, and no doubt of utmost concern to the Federal Reserve, Regulators and industry insiders – the sub-prime contagion seems to be spreading.
With the Mortgaged-backed / asset backed paper markets all but shuttered – the last thing in the world that the Fed would like to see is the Muni bond market falter. One might be led to think that someone with a sterling reputation like the Oracle of Omaha proactively lending his name and a vote of confidence to a beaten down sector would be reason enough to restore any wavering confidence, eh? Buffett is no stranger to politicos or names that have historically been synonymous with Central Banking.
Buffett pictured with Arnold and Lord Rothschild visiting Rothschild ancestral home in England circa 2002
Come to think of it, once you are talking about the integrity of Muni bonds – you really are only one step away from the holy grail of debt instruments – Treasuries – aren't you?
Overseas equities ended the year on a sour note with Japan's Nikkei Index falling 265 points to 15,307. North American Markets also stumbled with the DOW off 101.10 to 13,264.80, the NASDAQ down 22.18 to 2,652.28 and the S & P giving up 10.20 to 1,468.30. NYMEX crude oil futures added .03 to finish the year at 96.03 per barrel.
Interest rates eased about 6 basis points across the curve with the benchmark 5 yr. bond finishing at 3.45 % while the 10 yr. bond ended the day at 4.02 %.
On foreign exchange markets the U.S. Dollar Index added .55 to 76.63.
Precious metals had a somewhat mixed day with COMEX gold futures finishing down 2.60 at 837.00 per ounce while COMEX silver futures added .04 to 14.85 per ounce. The XAU was off 3.01 to 173.32 while the HUI dropped 4.63 to 409.37.
Wishing everyone a happy and safe New Year's Eve celebration and the very best in 2008!
© 2007 Rob Kirby