Warren Buffett-Municipal Bonds-Bond Insurers

| February 13, 2008 | 0 Comments

I love watching The Oracle of Omaha, Warren Buffett.  Yesterday, he caused the Dow Jones Industrial Average to move up over 130 points by making a simple announcement.  What did he say?  He offered to “help”, and I use that term lightly, troubled re-insurance companies Ambac (ABK), MBIA (MBI), and Financial Guaranty.

Whenever these offers arise, you have to analyze who they really help.

His offer really doesn’t benefit these companies much . . . and in my opinion may actually hurt them.  But, it did give me a great investment idea (more on that in a minute).

Here’s why this is a bad deal for these guys.

Ambac, MBIA, and Financial Guaranty are all big re-insurance companies.  They’re a little different from your homeowners or car insurance company in that they don’t insure people or property, they insure financial securities.  Here’s how it works.

Let’s say you work for the city and have been put in charge of building a water treatment facility.  The population is growing and everyone needs clean water.  You design the plant and get quotes from construction companies.  Before getting started you need to raise money for the project.

To do that you need to sell bonds.

To sell bonds, you meet with a number of investors.  These pension funds, insurance companies, and endowments all have billions of dollars to invest, and they like your project.  Best of all, your bonds are backed by the local government as they’re municipal bonds.  This provides a level of safety and gives tax advantaged status to certain holders.

But you have a small problem.  The interest rate investors want is higher than you anticipated.  You call one of the big re-insurance companies and find out that you can purchase insurance on your bonds.  Essentially, the re-insurance companies promise to make good on the bonds if your project fails.  This gives investors more comfort and allows you to get a lower interest rate.

Ambac, MBIA, and Financial Guaranty have worked with hundreds of local governments on thousands of projects.  They are currently insuring more than $800 billion worth of muni-bonds.

Now back to Warren’s offer.

In the muni-bond market prices have fallen.  Investors are afraid that problems in the real estate market will hurt the re-insurance companies.  Unfortunately, the re-insurance companies offered a similar type of insurance to CDOs and other mortgage backed securities – the ones having all the problems.  If the insurance companies suffer financially, their ability to make good on muni-bond insurance comes into question.

Warren has offered to provide new insurance to these muni-bonds, but only if the current insurers pay him 150% of the premiums left on the contract.  Remember, muni-bonds are backed by local governments supposedly making them some of the safest bonds around.

So, old Warren gets the safest part of the re-insurance portfolios . . . and they only need to pay a 50% premium.  This is a horrible deal for the re-insurance companies.  Not only would this transaction create a loss, they would have to give up the safest and most stable part of their business.  Warren would also get a leg-up for a new business he started just a few weeks ago . . . providing insurance on muni-bonds.  I doubt any of them will take him up on his offer (but we know how losses do tend to cloud people’s thinking).

However, the news gave me a great investment idea.

Warren invests in value – meaning he likes to buy things cheaply.  Clearly he sees value in the muni-bond insurance market.  That’s why he started a new business in this area.  Strong profit for an insurance company is driven by lower anticipated default rates.  If anticipated default rates are lower, than muni-bonds are currently undervalued.

I took a quick look at closed-end funds investing in muni-bonds.  Some of them are trading at discounts of 7% or more and have very attractive yields.  Depending on your portfolio and tax situation, now might be a good time to make some strategic investments into these muni-bond funds.

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Category: Bonds

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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