Warren Buffett Offers $800 Billion of Reinsurance for the Monolines
UPDATE 2: Wilbur Ross says he thinks the Buffett deal makes little sense but will pressure the regulators and banks to act. He is still working on a deal and will have better economics than the Buffett deal. I'm not really sure what the rating agencies think of all this.
UPDATE: Ambac just said it rejected the Buffett offer. Supposedly the company that rejected the offer before (that Buffett was referring to) was someone else (likely MBIA IMO). None of this should be a huge surprise to anyone. Buffett's asking price is steep no doubt. You know the price is too high when Bill Ackman says it's a good deal (LOL). The real question mark in my mind is what happens if the price is lowered. Then things get interesting... I still think if Ambac were to raise capital, reinsurance for some portion of the required capital makes sense.
Nothing surprising but Warren Buffett publicly announced that he is willing to underwrite (through reinsurance) $800 billion worth of municipal bonds. The offer was made to Ambac, MBIA, and FGIC.
I think MBIA is the one that rejected the offer. It makes little sense for them right now given that they already raised a lot of capital. As I have said before, reinsurance makes sense for Ambac depending on the price. Based on rating agency opinion of the AGO transaction, Ambac would have to give up around $100 billion in muni bonds to secure $1 billion in capital.
The price is very steep: 1.5x premium received. Basically you will not only not make any money on the muni bonds but also lose up to 50% (but unearned premiums are invested in low-risk bonds, the actual loss may be more like 30%). Since muni bonds typically have low premiums, this loss isn't as bad as it seems. Issuing shares or debt is likely more expensive than losing 50% on muni bonds. Depending on details, issuing stock means you are giving up around 20% earnings yield (say a normalized P/E of 5), and around 15% for debt-like instruments.
I'm sure that Berkshire Hathaway isn't the only one offering reinsurance so one should be able to shop around. The other big reinsurers like Munich Re, Swiss Re, along with the small Bermuda-based reinsurers will likely consider reinsuring muni bonds. Some stories are saying that reinsurers are doing poorly because premiums for catastrophes (eg. hurricanes, earthquakes, etc) are down this year so I'm sure many would consider municipal bond reinsurance, which is historically a very low risk activity.
If Ambac is reasonably sure that it can maintain its AAA rating then unloading the muni bonds is a good strategy (if they don't care about AAA, then Ambac doesn't have to do anything since it was around $2 billion over the AA-required capital limit in January (this was for S&P I believe)). The problem is that rating agencies are very flaky these days and one can never be sure what they are thinking. Given the fact that none of them have given a hard target of any sort, reinsurance is a risky proposition.
Without being a financial expert or being privy to confidential information, I would prefer of Ambac reinsures around $100 billion of muni bonds (to generate $1 billion in capital) and does a share rights offering of $500 million to $1 billion. This is assuming we can get a somewhat solid opinion from the rating agencies.
UPDATE: Ambac just said it rejected the Buffett offer. Supposedly the company that rejected the offer before (that Buffett was referring to) was someone else (likely MBIA IMO). None of this should be a huge surprise to anyone. Buffett's asking price is steep no doubt. You know the price is too high when Bill Ackman says it's a good deal (LOL). The real question mark in my mind is what happens if the price is lowered. Then things get interesting... I still think if Ambac were to raise capital, reinsurance for some portion of the required capital makes sense.
Nothing surprising but Warren Buffett publicly announced that he is willing to underwrite (through reinsurance) $800 billion worth of municipal bonds. The offer was made to Ambac, MBIA, and FGIC.
Buffett said that under the offer, Berkshire would assume the liability for the bonds in exchange for a payment from the current insurers of 1.5 times the premium they are receiving. Buffett said one firm rejected the offer, and the other two have not responded.
I think MBIA is the one that rejected the offer. It makes little sense for them right now given that they already raised a lot of capital. As I have said before, reinsurance makes sense for Ambac depending on the price. Based on rating agency opinion of the AGO transaction, Ambac would have to give up around $100 billion in muni bonds to secure $1 billion in capital.
The price is very steep: 1.5x premium received. Basically you will not only not make any money on the muni bonds but also lose up to 50% (but unearned premiums are invested in low-risk bonds, the actual loss may be more like 30%). Since muni bonds typically have low premiums, this loss isn't as bad as it seems. Issuing shares or debt is likely more expensive than losing 50% on muni bonds. Depending on details, issuing stock means you are giving up around 20% earnings yield (say a normalized P/E of 5), and around 15% for debt-like instruments.
I'm sure that Berkshire Hathaway isn't the only one offering reinsurance so one should be able to shop around. The other big reinsurers like Munich Re, Swiss Re, along with the small Bermuda-based reinsurers will likely consider reinsuring muni bonds. Some stories are saying that reinsurers are doing poorly because premiums for catastrophes (eg. hurricanes, earthquakes, etc) are down this year so I'm sure many would consider municipal bond reinsurance, which is historically a very low risk activity.
If Ambac is reasonably sure that it can maintain its AAA rating then unloading the muni bonds is a good strategy (if they don't care about AAA, then Ambac doesn't have to do anything since it was around $2 billion over the AA-required capital limit in January (this was for S&P I believe)). The problem is that rating agencies are very flaky these days and one can never be sure what they are thinking. Given the fact that none of them have given a hard target of any sort, reinsurance is a risky proposition.
Without being a financial expert or being privy to confidential information, I would prefer of Ambac reinsures around $100 billion of muni bonds (to generate $1 billion in capital) and does a share rights offering of $500 million to $1 billion. This is assuming we can get a somewhat solid opinion from the rating agencies.
Just for the sake of argument, what if if was Ambac that declined? With MBI having already raised 2.5 billion and showing they are fully committed to keep the AAA, if they were to pick up an additional x amount thru reinsurance via Buffett, it seems to me the ratings agencies would be hard pressed to downgrade. It would be Moody's vs Buffett (and Buffett owns 20% of Moody's!)
ReplyDeleteAlso, there is still that bank consortium in wings for Ambac, and maybe they are working that.
Plausible?
Other than that, the bears are working hard and things seem pretty bleak.
Or perhaps an ABK deal with Buffett will go hand in hand with a bank line and stock offering.
ReplyDeleteLots of permutations.
Well, given that Bill Ackman likes the Buffett plan, maybe this plan is bad for the monolines ;)
ReplyDeleteI think if Ambac were to retain its AAA rating, it would need a combination of ideas. Single tactic isn't enough (unless you want massive shareholder dilution)... of course, if keeping the AAA is expensive, it can try to survive with AA (will have to give up most of the muni bond business)...
One other thing is that I don't see why other reinsurers can't offer a better deal. Buffett is probably offering an extremely high price...
ReplyDeleteI admire your peserverance with this position, but I think you need to consider how much more value you are willing to lose as the next few cards are turned over.
ReplyDeleteI won't rehash all the structured finance exposure, but will only point out that this week brings news of forced liquidations of market value CLOs which can't be doing anything positive for the CDO exposure that Ambac has. Moreover, the hits are coming fast in CES and HELOCs as well if you look at what the mortgage originators and banks are reporting.
There may be a better offer than Buffett's that will surface, but the financial institutions of the world with excess capital and AAA ratings are in short supply these days. AIG - see yesterday's news, Swiss RE took a good sized hit in structured finance and now has Buffet in their hip pocket. Remember there are 3-4 firms that need bailouts here and we are talking about a fair bit of capital in the aggregate.
Beyond that, I think this offer pretty much rules out any kind of rescue other than from the banks that already have exposure to the monolines. Buffett is the guy best positioned to do a save and he's stating very forcefully that he wants nothing to do with the structured finance exposure. The banks, who are already pregnant here, are the only ones who will walk out into the mindfield. They are being asked to essentially pay for the losses that they have been insured against. It might at the end of the day makes sense for them to do that if it preserves the claims paying ability of the monolines, but in return, they will ask for most if not all of whatever residual value is left at the insurance company level when all is said and done.
MBIA has taken a different route - time will tell whether they chose a better course. But even with the advantage of moving early to secure capital at much higher prices have produced massive dilution that is probably going to get worse before the problem will be sovled, if it can be solved. To expect a markedly different outcome in Ambac is wishful thinking, I believe.
Thanks for the response Brian. Let me try answering some of your key points. It may shed some light on why I'm still sticking with the position...
ReplyDeleteJust because things look bad doesn't necessarily mean that it is time to change the position. I believe that the market is irrationally pricing in things. A good example is how insured bonds were trading below similar non-insured bonds. That makes no sense. If bond buyers, who are supposed to be sophisticated, are dumping anything that is attached to a bond insurer, you know there is a lot of irrational behaviour occurring.
Secondly, the time to bail was late last year. We have sort of hit the point where most--maybe not all--of the bad news is priced in. When the ABX index, which is worse than the actual exposure of most monolines, drops from 100 to 30for some of the lower quality tranches, how much more is there to go? Yes, things can deteriorate further but how much more?
The fundamentals for subprime mortgages actually look better now than 3 months ago in my opinion. I remember reading somewhere that some people's mortgage payments are lower than they were a few months ago (if they re-financed now). Interest rates are lower, some lenders are willing to re-negotiate the deal, and the US govt is cushioning some difficulties faced by low-income borrowers.
As for Warren Buffett, he is not saving anyone. He is acting in his self-interest and he makes that clear. If the monolines don't raise capital, that sucks but it's fine. They'll just go into run-off and there should be some positive value. Even a somewhat bearish estimate from Goldman Sachs had Ambac being worth $15 in a run-off.
Having said all that, what will make me cut losses?
Well, the answer is simple. If I feel that fundamentals have deteriorated then it's time to bail. If Ambac actually takes sizeable losses over the next 6 months, I'll have to consider cutting losses. So far, it's all speculation and most of the losses are mark-to-market losses.
House Finance subcommittee hearing tmw. Here's the panel lineup.
ReplyDeleteHouse
Marketwatch has advanced word on what Bill Ackman will say tomorrow... nothing new in my eyes but wonder what the hearing will accomplish...
ReplyDelete"Just because things look bad doesn't necessarily mean that it is time to change the position. I believe that the market is irrationally pricing in things. "
ReplyDeleteI have to agree with Brian here, it seems like... you're pretty fixated on making big bullish investments in areas that have been particularly hit hard by the turmoil in the credit markets.
ex: your position in DFC, things looked bad - and they were bad. You ended up selling for quite a bit of a loss.
Then, now, you put 25% of your capital into another company particularly hurt by the credit crisis - a company who now has the potential to be at the whims of billionaires offering to bail them out, or a bailout by the US government.
It just seems to me that monoline insurers are not good businesses, they were when they only dealt with munis, but the structured credit products have really done a number on them, the companies are grossly overleveraged and it seems to make little sense.
I just don't think you're employing good restraint with the sizes of your positions and you place a major part of your portfolio at risk. Mohnish had a huge loss in DFC, but at least it was only 10% of his portfolio - with you and ABK, the situation might be much worse.
Hopefully, Ambac & MBI will put on a good show. I think Callen will be a calming antidote to Ackman, and should do well in a Congressional forum.
ReplyDeleteMichael A. Callen- President, Avalon Argus Associates, LLC (financial consulting) since April 1996. Mr. Callen was Special Advisor to the National Commercial Bank located in Jeddah in the Kingdom of Saudi Arabia from April 1993 through April 1996. He was an independent consultant from January 1992 until June 1993, and an Adjunct Professor at Columbia University Business School during 1992. He was a director of Citicorp and Citibank and a Sector Executive for Citicorp from 1987 until January 1992. Mr. Callen also serves as a director of Intervest Corporation of New York and Intervest Bancshares Corporation.
I appreciate your thoughts Viktor. I've thought about these risky areas but we'll see how things work out...
ReplyDeleteCak,
ReplyDeleteThe hearing is going to be a big battle between the monolines and the doubters. MBIA is supposedly going to attack Bill Ackman directly in the hearings. I personally don't like it when companies try to curtail short-selling (I think shorts increase efficiency in the markets) but I am cool with them questioning how Bill Ackman became an expert representing the industry.
I totally agree. MBI should stick to business and not worry about short selling or "stock manipulation". MBI may be targeting "naked" short sales, etc. but, from a public relations point, it usually backfires. The bears end up making the accusing party look paranoid and provides more fodder to shine negative light on the company.
ReplyDelete