Friday, December 28, 2007 12 comments ++[ CLICK TO COMMENT ]++

Berkshire Hathaway Enters the Bond Insurance Market

UPDATE: According to this news article, Berkshire Hathaway Assurance will be capitalized with $105 million, with more depending on business performance. If we go with a typical 100-to-1 par insurance value (Berkshire Hathaway Assurance may use a slightly lower value while charging a higher price), then it will be insuring around $10 billion. That's very small (Ambac's public finance total par value exposure is $300 billion, with Ambac writing around $20 billion of new insurance per year). So the Berkshire entrance won't be a giant gorrilla entering the industry; it will be more of a nimble start-up, likely working its way to bigger things.


UPDATE 2: A couple of interviews with Buffett by Fox News regarding his bond insurance move (Thanks to Reflections on Value Investing for the original mention).


Well, I have commented on the possibility before and it finally happened: Warren Buffett's Berkshire Hathaway is setting a bond insurance unit, Berkshire Hathaway Assurance, to insure municipal bonds (original WSJ story here (requires subscription)). I always thought there was a possibility of Berkshire Hathaway setting up a new business or buying out one of the existing bond insurers. There is good news and bad news in this for the other bond insurers--mostly bad news though.


The Good News

The good news is that this move gives credibility to the bond insurance business. There have been many stories of late saying that the bond insurance business is almost a scam and not needeed. The thinking by some of those who hold that view is that muncipalities, not to mention banks and others, will stop using bond insurance and simply issue uninsured bonds. Well, that argument has now been weakened by the fact that the best investor of all time actually thinks it is a viable business worth entering. Warren Buffett is a value investor so we can be sure that he isn't entering the market due to some short-term fad or trend.


The Bad News

The bad news is that this is going to be a huge competitive force to Ambac, MBIA, and the rest of the monolines. I actually thought about this competitive force (or one of the mega-reinsurers like Munich Re or Swiss Re entering) before so it isn't surprising to me. Berkshire Hathaway is one of the few corporations rated AAA so we can be sure that Berkshire Hathaway Assurance will likely be rated AAA as well. This means the big threat is to the AAA-rated monolines (eg. Ambac) and not the lower-rated monolines (eg. Radian). I suspect Berkshire Hathaway Assurance will not compete much against Radian and its sub-AAA peers.

Based on the news article, it seems like Berkshire Hathaway Assurance is interested in municipal bonds and not the structured products (like credit card debt, student loans, mortgage loans, and, of course, CDOs and CDO-squareds). I know the monolines have had a horrible experience with the structured products (especially anything mortgage-related) but it presents an opportunity to solidify their position in the structured product area--an area I believe holds the biggest potential in the future. It looks like Berkshire Hathaway Assurance will stay clear of structured products. This would be consistent with the fact that Warren Buffett doesn't like derivatives and other "fancy" products that are common in the structured product area. For instance, I'm not sure if Buffett would be comfortable with pay-as-you-go-type CDS contracts used by monolines for their structured product insurance. Having said that, there are experts within Berkshire Hathaway's insurance units that may have a good grasp and liking for structured finance products and may convince Buffett to enter this market (for example, how many Berkshire Hathaway investors would have thought that Berkshire would be the largest mega-catatrophic reinsurer right now? Buffett himself was probably convinced to enter this market by others like Ajit Jain (this is all speculation on my part but that's my feeling)). Similarly, the structured product market is an opportunity. This won't happen any time soon (not until Berkshire Hathaway Assurance establishes itself) but is a long-term competitive threat to Ambac, MBIA, FGIC, et al.



My Expectation

I considered the possibility of one of the big reinsurers, Berkshire Hathaway, Munich Re, or Swiss Re, entering the bond insurance business when I first thought about Ambac. My view now is the same as back then. Namely, Berkshire Hathaway Assurance isn't as big of a threat as it seems.

I think the market will be tougher but there is enough room for growth for all. This is definitely not a saturated mature market (emerging markets, not to mention developed countries like Japan, have very low bond insurance use). US municipal bond insurance is going to be far more competitive but there will be room in other areas. As I remarked above, structured products also will likely have low competition.

The bond insurance market seems to be an oligopoly-like business at the high-end (i.e. AAA-rated insurance). I believe it will be difficult for more than 4 or 5 companies to retain their AAA rating for a long period of time. Once the latest shakeout is over, it will be even more difficult to raise capital to maintain AAA rating (investors are going to steer clear of this industry for a while IMO).

It will take a while for Berkshire Hathaway Assurance, or other new competitors, to get set up in all of the American states. If the plan to go into Europe, it will also likely take some time to set up operations there. The big question for existing monolines is the value attached to their brands by their customers. I don't know enough about the industry to know if a customer actually discriminates between the differing, but similarly rated, bond insurers. The existing bond insurers, especially those that have been in business for more than 10 years, also likely have some expertise that cannot be easily duplicated by new entrants. A lot of the contracts that they write seem to be complicated and if you don't price the risk properly, you won't stay in business for long.

The other thing to note is that Berkshire Hathaway Assurance looks like it is going to charge a premium rate for high quality insurance. This will necessarily keep their market small, and the existing bond insurers may be able to do ok by undercutting for slightly worse brand recognition and support.


Buffett's Thought On Bond Insurers' Key Mistake

On a different note, in this article, Buffett says that bond insurers mispriced risk:



Buffett tells the Journal that for years bond insurers didn't charge enough to justify the risks they were taking on because they were so interested in getting new business. "We felt that in many cases, the prices that people (bond insurers) were charging were inappropriate. As long as people (debt issuers) were willing to accept that, there was no point in trying to offer something else." Now that the credit ratings of the old-line bond insurers are in jeopardy, Buffett sees an opportunity. "It could be tiny, it could be very large. It'd be nice if it were large, but we're not pushing for that."


If anyone wondered what the bond insurers did wrong, there you have it. They mispriced the insurance. This is actually an easy mistake for insurers to make. A lot of the smaller reinsurers who nearly went bankrupt after Katrina also made the same mistake.

Tags: ,

12 Response to Berkshire Hathaway Enters the Bond Insurance Market

Neanderthal
December 28, 2007 at 3:37 PM

Well, they certainly have the name recognition and financial backings. I don't know if it is that easy to do this well. Judging from the superficial and third hand data, even among the existing companies, some are better than others. I got a feeling that ABK got a lot better deals out of the CDOs compared to MBI. In the end, one must bow to competitive pressures. If that is the only business you do, you either price the products right or stop doing business. The underlying expertise of the team is not that easy to replicate.

John

cak
December 29, 2007 at 1:19 PM

Hey SIV -

Happy New Year. I hope you make a ton!

I don't know if you've seen this from Marty Whitman, explaining his reasoning behind Third Ave's recent investments in MBI and RDN.
This is the Value Funds 4th qtr report dtd 10/31, 07. He goes quite in depth, and is a good read.

Marty Whitman

If link is no good, access Third Ave Funds/Mutual Funds/shareholder letters/Value Fund

December 29, 2007 at 1:24 PM

Yeah... let's just hope that Ambac understood what they were doing better than the competition. They clearly have the higher CDO exposure.

One thing that I like about Ambac is that they are far more transparent than the competition. The fact that they were willing to detail their exposure to the questionable stuff gives me greater confidence. This doesn't mean that they won't sink but if they do, they would have done so holding their heads high.

Berkshire Assurance is going to be very small. The way they are pricing things (premium price for premium guarantee) also likely will keep their market small. Unless Buffett changes their strategy in the future, they look to be the Louis Vuitton Moet Hennessy of bond insurance. It'll be quite interesting to see how this plays out.

If they charge a premium rate, does that mean that they will attract the riskier bond issuers or does it mean they will attract the larger bond issuers?

December 29, 2007 at 3:29 PM

Thanks for the Whitman link cak. It came out earlier than I thought and it contains good information. I'll write up a post later.

Interestingly, he didn't say anything about Ambac so does this mean he doesn't think it is as good as, say, MBIA?

I also wonder if betting on multiple bond insurers may be preferable to betting on one. Martin Whitman is clearly betting on the industry rather than anyone specific.

cak
December 29, 2007 at 3:29 PM

You make a very interesting observation with respect to structured products. For now, and most likely, for as long as he is alive, Buffett will not touch the stuff, preferring to charge premium rates to insure top tier municipals.

Per Bloomberg, "Bonds sold by state governments make up about 33 percent of the insurance premiums collected by MBIA, the biggest of the monolines, and 50 percent of revenue for No. 2, Ambac."

So, obviously, ABK & MBI made major moves AWAY from the muni business (and into the the stuff that is killing them now) in an effort to grow.

So, in light of the current meltdown, does this spell the end of structured product coverage? Or will it make it that much more necessary (just as the stifling default of Washington Power in 1984 enhanced the value of having muni insurance)?

While there has been current talk critiquing the usefulness of muni insurance, can the same be said of structured stuff? It was interesting to read Buffet's comment about the bond insurers "mis-pricing of risk". He never said MBI, ABK, etc were wrong to enter the arena (ABK did its first ABS transaction in 1994), just that they didn't charge enough at the front door.

It would seem, that if the market for non-muni insurance is viable,
a strong player who does know how to "price the risk" will make an awful lot of money?

I went onto Ambac's website and checked out their history. They've been thru some bumpy roads before.
What is interesting is that it took them 8 years from their founding in 1971 to garner a AAA rating from
S+P. In 1983, their parent company Baldwin United went bankrupt. Then, in 1984, they get hammered by losses in WHOOPS bonds, almost go under, but get bailed out by (of all folks) Citicorp.

cak
December 29, 2007 at 4:01 PM

"Interestingly, he didn't say anything about Ambac so does this mean he doesn't think it is as good as, say, MBIA?"

I'm going to play Pollyana here and say maybe Whitman thinks Ambac is NOT as bad as MBI or RDN (ha ha), and maybe doesn't qualify as a distress play.

Or maybe back in the 3rd qtr, with the general view being that MBI was in better shape than ABK (you mentioned that also) Whitman thought MBI was the smarter play.
Maybe he's looking at ABK now.

Actually, what I think turned Whitman's head to MBI was the Warburg deal. He talks about the 500 mill rights offering and its moderately dilutive effect. I guess that is huge for someone like Whitman who is obsessed with book valuations, although Im somewhat confused about dilutive vs. non-dilutive relative to a rights offering.

I wonder if AMBAC has a plan mirroring MBI? Hopefully, we'll know soon - Fitch has pretty much set the calendar.

December 29, 2007 at 7:33 PM

Cak, good thoughts. Martin Whitman certainly made some unusual comments. I'm also kind of puzzled by him saying that a rights offering is non-dilutive. If you are willing to put in more money--and Whitman will--then it may not be dilutive but for any other shareholder it will be extremely dilutive.

I also find it interesting that he says that stock offering or rights offering is the best. This seems bizarre--again, unless you are willing to put more money into the business--given that preferred share offering or buying reinsurance is generally cheaper. However, it is quite possible that the cost of a preferred share offering or buying reinsurance may have gone up significantly in the last few months and a stock offering may be cheaper.

The most powerful comment from Whitman, at least for the bulls, is his view that even if a company like MBIA winds down its operations, it is still a positive investment.


Ambac needs to raise $1 billion and I'm expecting a big rights offering, along with a stock sale. Something similar to what MBIA did is what I'm expecting. Shouldn't be too hard to get some distress fund or a value-investing-type fund to pony up some of the money (not to mention foreign money in Asia or Middle East)...

cak
December 31, 2007 at 11:40 AM

Siv-

I posted this over on AI's blog - a new article from Reggie Middleton. It almost appears as a challenge to AI, considering the timing.

It's a rather shrill blog, continuing his all out assault on the ratings agencies

ReggieMiddleton

cak
December 31, 2007 at 11:48 AM

Sorry to inundate you with so much material but, incredibly, here is a positive take on the business

BondBuyer

cak
December 31, 2007 at 2:13 PM

Siv-

You might find this interesting vis a vis dilution. I wish I was smart enough to get a firm grasp - too many New Year's have ravaged my brain cells.


RightsDilution

January 2, 2008 at 1:40 PM

Cak, I appreciate you posting references to those articles. Keep posting. They are helpful to me--and others I'm sure.

October 16, 2008 at 9:55 AM

Keep up the good work.

Post a Comment