Why the Banks Hate White Knight Buffett

February 13, 2008

A big fight between the people of the U.S. and Wall Street is developing. At issue is a federal bailout for the three big bond insurers MBIA, Ambac and FGIC. Yesterday the banks lost a big advantage in this. Now more campaigns funds will flow.

The three insurance companies each have two lines of business. The traditional and relative sound one is to provide insurance against the default of municipal bonds. Such bonds are used by all states and bigger cities in the U.S. to borrow money for investment and their daily business. Uninsured bond issues have to pay much higher interest or will not find any buyers at all.

The newer line of business for the bond insurers are the various fraudulant mortgage bonds and their derivatives, CDOs and MBSs, through which major business banks resold bad debt under faulty triple A ratings. Now, as the bad debt bonds have been exposed as such, the insurers will have to pay for their default. But they have too little capital to do so. They will go bust any moment now.

When that happens the uninsured old municipal bonds will immediately fall in value. Depending on the individual contract some bondholder may demand immediate re-payment of the total outstanding loan. For some municipal entities like the city of Pittsburgh, bankruptcy would then be inevitable.

Even if there are no immediate re-payment triggers, the consequences for municipals will be harsh.

Like all ‘eternal’ entities municipals never pay back debt but issue new bonds to pay off old debt. When the insurers go bust and the old municipal debt is downgraded, it will be hard to get new credit at all.
Without sound insurance new municipal bonds already fail to find buyers.

Yesterday the Maryland State and Health and Higher Educational Facilities Authority and the California Statewide Communities Development Authority were unable to get fresh money. The Michigan Higher Education Student Loan Authority stopped issuing student loans because it could not refinance. Rates for fresh debt of the Port Authority of New York jumped to 20%. Without capable insurers, the U.S. taxpayers will have to pay these very high rates or will lack the services that are supported with these municipal bonds.

Up to yesterday the only hope for the municipals was a federal bailout of the bond insurers.

But then came a white knight in the person of Warren Buffett. He offered to take over the complete municipal book of business of MBIA, Ambac and FGIC. This would save the municipal debt market, the issuers and the bond holders. But the three bond insurers would be left with the liabilities for the "big shit pile" of mortgage backed loans in their second line of business.

Municipals and the individual taxpayers will love the Buffett offer. Sure, he’ll make a big profit insuring there future bonds. But it will be much cheaper to pay Buffett, than to pay the high rates they would need to pay without insurance. It is also better than a federal bailout which, in the end, would take away the same taxpayer money that supports the municipals.

But Wall Street is very unhappy with the Buffett move. One can expect them to try everything possible to derail it. The owners of the big banks also hoped for a federal government bailout of the bond insurers. If such a bailout does not happen – and it is much more unlikely when the municipals are secure – the big banks will have to write down the value of all their CDO, MBS and other bad debt holdings. This could trigger a financial crisis and some of the big banks would probably go bankrupt.

To avert such a crisis, if possible at all, might still be an argument for a taxpayer bailout. But before the Buffett offer the municipals had a motive to lobby for a federal bailout of the insurers. Now the banks are on their own and even many more millions of campaign dollars may not be enough to get this done.

The finance, insurance and real estate sector already put some $80 million into campaign funds. Her Clintoness is their dearest target. Expect the numbers to surge as the fight for a federal bailout of the bond insurers will intensify.

Posted by b on February 13, 2008 at 17:19 UTC | Permalink

Comments

Thanks for taking up this topic, b. You’ve added much needed clarification. For me, I should say.

Posted by: Hamburger | Feb 13 2008 20:55 utc | 1

Yes, much clarification for me also. Thanks B and please keep us informed with your news and comments on this subject as things develop further.

Posted by: Rick | Feb 13 2008 21:49 utc | 2

I agree that Buffet would take the cream and muni bonds are real safe. We issue them and our interest rate is very low. In fact, many municipalities do not need insurance, because the chance of default is very low and small and medium size communities are very safe and they still have the default shame standard.
But another interesting twist is about to take place in the muni bond worlds. New GASB (Governmental Accounting Standards Board)rules were issued that take effect this year. It requires that units of government to list long term obligations (project)for any type of pension and insurance liabilities for employees that are about to or have retired. This information will go in the yearly audit. Many municipalities have high long term obligations that are currently hidden, and when they show up in the audit it will hurt their bond rating.
This will allow bond holders to extract even more interest from locals and create a more teared system of bond rating. And with billions of dollars worth of infrastructure needs across the US due to a lack investment in the US over the last thirty years, this will allow the rich to extract more from the country. Tax free munis are a good investment. Especially when you consider the default rate which is next to zero, and you could get higher interest from a safe investment.
The real kicker though is how some will solve this situation. First, many local governments are pushing states to allow “bonding” to take care of long term pension and insurance obligations. Second, locals from east to west will cut pensions and insurance obligations as states push to have repeals of binding arbitration laws and make states right to work states with no union obligations.
Municipalities cannot afford lower bond ratings when doing projects.

Posted by: jdp | Feb 14 2008 0:14 utc | 3

What we refer to as ‘big shit pile’ today, Buffet referred to in 2002 as ‘toxic slime’, stating that he would have nothing to do with the whole CDO scam. He was right then, he’s right now.

Posted by: mikefromtexas | Feb 14 2008 0:59 utc | 4

wow

Posted by: annie | Feb 14 2008 1:57 utc | 5

@jdp, thanks. I always enjoy the info. & insights you share w/us. I wonder if those new rules went into effect ‘cuz elites ready to go to war to destroy pension plans. @local level, they can say to citizens, who themselves are being laid off & have had their pensions destroyed by the Predators, gee shucksypoo, our little podunk berg will go bankrupt if we pay out these pensions….Pitting us all against each other…
b- , I’m really glad you did this thread. I was gonna do a late night post asking you to translate this into English, as I wondered what you thought of it, etc. Here’s an analysis from a site Unca shared w/us ~last Fri., highly recommending it’s Ney art:
The price Buffet’s asking from the bond insurers for this reinsurance is all the income (cumulative incoming premiums on ongoing basis) on their munipal bond business plus another 50%. Thus, the insurers would pass thru to Buffet all their income on their muni business and pay him another 50% for the privilege.
Buffet justified this 150% take by noting that his new bond insurance company, formed late last year, is already receiving 200% from individual muni bond issuers to reinsure their bonds. So his offer to do it wholesale — to reinsure the entire $800 billion of munis that these three monolines currently insure — for 150% is, from one angle, cheap.
Nevertheless, by stripping the insurers of their reliable, secure muni income, and doing nothing to fix their bleeding s-f business — which almost certainly will bankrupt them unless somebody gives them a ton of support, which Buffet has now publicly declined to do — the plan is no better, for the insurers, than a vulturous bankruptcy wind up.
It IS better for the muni bondholders currently insured by the distressed monos, in that they would know they’ve got the Buffet backstop regardless of what happens to the monos.
But there seems no reason for the bond insurers or their shareholders to celebrate here. They are indeed being picked by a (gentlemanly salt of the earth) vulture.
None of the insurers have accepted this lousy offer. One suspects Buffet has now gone public with it in a spectacular way (the half hour call on tv) because he wants the world to know he’s waiting outside the door when the bond insurers get drawn into bankruptcy or similar regulatory regimes. At that point regulators one way or another will cut the municipal bond business from the carcasse. Warren Buffet & the Monoline Bond Insurers

Posted by: jj | Feb 14 2008 3:24 utc | 6

@jj – not much to translate
The “Monoliners” as these insurers are called are in reality “Duoliners” (as explained in my piece.) Buffet will take the municipal business line, of course for as big a profit as possible, and the rest will go down as it should.
I agree that they will have to – unless the big banks bail the isurers out. But that is very unlikely. If your wholre town is burning and the fire insurance company is somewhat dubious would you buy the likely bankrupt insurer? Doesn’t make much sense. But watch the politicians …

Posted by: b | Feb 14 2008 6:18 utc | 7

Thanks, b-. When I say translate into English, I’m referring to the fact that economics might as well be written in Russian to the economically illiterate, unless carefully decoded to make the connections that we’re incapable of 🙂

Posted by: jj | Feb 14 2008 6:52 utc | 8

A while ago the Fed discontinued to report M3, a measurement of how much money it creates. The obvious reason was not let anybody know how inflationary their policy is.
So it is not astonishing, though slightly funny, to read this: Due to budgetary constraints, the Economic Indicators service (http://www.economicindicators.gov) will be discontinued effective March 1, 2008.

Economic Indicators.gov is brought to you by the Economics and Statistics Administration at the U.S. Department of Commerce. Our mission is to provide timely access to the daily releases of key economic indicators from the Bureau of Economic Analysis and the U.S. Census Bureau.

“budgetary constrains …”

Posted by: b | Feb 14 2008 8:04 utc | 9

This article just appeared in a russian media outlet
It seems Iran intends to finally launch the bourse. Watch the money markets if the launch happens, particularly the effect on the dollar. And watch for any strange disruptions to the www
You know, if your a paranoid like me…lol

Posted by: Anonymous | Feb 14 2008 9:11 utc | 10

harsh consequences, yes, but not so long-lasting for the municipalities. as most of those bonds are callable, the agencies can refinance when the smoke clears. they’re whining, not dying, and if the banks stop Buffet they’ll be alright soon enough.
the real risk of their transient owie is that the pain panics additional more vulnerable sectors

Posted by: …—… | Feb 14 2008 10:45 utc | 11

@11 – any background why you come to those conclusions?
—
The insurers get a bit of a bailout by Freddie Mac changeing its rules:
Freddie Mac: Project MI Lifeline? quotes something

Freddie Mac (NYSE: FRE) today announced it is temporarily changing its Private Mortgage Insurer Eligibility Requirements [PDF 160K] in order to increase the claims-paying and capital retention capacities of its mortgage insurance counterparties during the current market correction.

Quite complicate but it seems to be that this takes risk away from the insurers and up to FreddieMac.
Freddie is backed by your taxdollars, so if this goes wrong (I assume it will) its your money on the line …

Posted by: b | Feb 14 2008 16:55 utc | 12

if by conclusions you mean ‘the real risk…,’ I’m thinking this is just more of the same in a specialized and not-so-vulnerable part of the credit markets. Municipal agencies can always get somebody to insure them. Auction-rate securities were just never so spunky before, and this of course alarms the old ladies and dim sons of rich men who buy them (like droll Port-Terminal heirs the Mahers, who just embarked on arbitration over a $286M paper loss – they told Lehman Bros. to put their $600M sellout windfall into munis, don’t laugh, that’s not nice). What’s scary about this is to see the credit trouble spreading, spreading.
Tax dollars… dollars, yeah, I remember those.
The worse, the better.

Posted by: …—… | Feb 14 2008 19:21 utc | 13

The Powers That Be/Are have declared that my city(Louisville,Ky) will have a new arena with a projected cost of 350-375 million(Before cost over runs take it to 425-450?). I have been hopeful that the project would have to be put on hold because of the increased cost and difficulty in floating the bond issue to pay for this nightmare.Put on hold for years and years. Yesterday our dear Mayor for Life said that because of more people bidding(They don’t have any other work) AND the LOWER rates on muni bonds,the project could bebrought in for 30-50-70 million less than thought.SAY WHAT!…….I have to quit banging my head against the wall because it makes me forget my grandkid’s names!

Posted by: R.L. | Feb 15 2008 5:25 utc | 14

Krugman – A Crisis of Faith

loss of trust can be a self-fulfilling prophecy. Now that new investors won’t buy auction-rate securities because they no longer believe that they’re as good as cash, those securities become a much worse investment.
Needless to say, all of this is bad for the economy. I like to think of what’s happening as a sort of minor-key reprise of the banking crisis that swept America in 1930 and 1931. Frustrated investors who can’t get their money out of auction-rate securities aren’t as photogenic as angry mobs milling outside closed banks, but the principle is the same. And so are the effects: would-be borrowers can’t get credit, and the economy suffers.
One simple measure of the seriousness of the credit problem is this: although the Federal Reserve has sharply cut the interest rate it controls over the past few weeks, the borrowing costs facing many companies and households have actually gone up.
And the financial contagion is still spreading. What market is next?

Posted by: b | Feb 15 2008 7:09 utc | 15

No 1 is giving up: Bond insurer FGIC seeks break up

Troubled bond insurer Financial Guaranty Insurance Co. asked New York state insurance regulators to split its troubled structured finance arm from its healthy municipal bond insurance business, New York Insurance Superintendent Eric Dinallo said Friday.
In a televised interview, Dinallo told CNBC that the New York-based FGIC proposed the offer after seeing its credit rating downgraded by the Moody’s Investors Service a day earlier.

Let’s see if Buffet picks up the good part …

Posted by: b | Feb 15 2008 17:54 utc | 16

Buffet’s having a fine time screwing around with stuff like this, but of course no one bit on his “insurance” ploy (unless you want to count the moron daytraders who used this “news” to bump the bear rally up for a day while articles like this one were bandied about.
But of course, no one’s taking The White Knight up on his offer of sitting on his sword.

Posted by: Fade | Feb 15 2008 20:40 utc | 17

Roubini argues that the good part of the “monoline” insureres isn’t good at all.

The four factors discussed above suggest that the conventional wisdom that state and local governments rarely default will be seriously tested during the current economic recession. And if the current recession will end up – as likely – being more than the previous two investors and markets will be shocked to discover that their presumption that default rates on muni bonds are always low will be proven to be wrong. But if the default rates on state and local government were – as argued here – likely to soar in a recession the consequences – in terms of losses for financial institutions and investors – would be massive. Certainly financial markets have not priced so far the risk of a significant increase in default rates on muni bonds. But then they had not priced either the risk of subprime mortgages’ defaults or the risk of a sharp increase in corporate defaults.
Thus, the risk of a historical regime break – with a sharp increase in default rates on muni bonds – should not be underestimated. If that were to happen the current delusion that the only problems of monoline insurers are in their insurance of structured finance products and that insuring muni bonds is a profitable cash cow could soon be dashed. Then the ensuing systemic effects of a rise in muni bond default rates would be an order of magnitude larger than those of an already large writedown of the toxic structured products currently insured by the monolines.
So, in conclusion, caveat emptor: muni bonds may be much more risky and subject to default than the current conventional wisdom makes them. A serious US recession may reveal what has not occurred for a quarter of a century: a sharp increase in default rates by state and local governments.

Hmm – sounds right to me, though I don’t knwo what is involved in a muni default. What is the collateral of U.S. municipals? Schools, roads? Is there one?

Posted by: b | Feb 16 2008 8:18 utc | 18

You can’t repossess a bridge. all you care about is agencies’ capacity for debt service. Any solvency issues would be very slow to reach the critical point because taxation is easy, not like earning money. You just demand more. Pension liabilities are the weak link. In that respect many jurisdictions are already broke. Those governments will choose between jacking up taxes and fucking their civil servants, or most likely, both. A threat of default is just a labor relations stunt. Actual sudden default takes a Bush-like gift for fucking up. In Orange County CA it took clownish speculation in swaps to sink them.

Posted by: …—… | Feb 16 2008 13:10 utc | 19

Great catch b.
If we did get to that point it could be from a couple of factors. First, infrastructure assets are not pledged. Its the full faith and credit of the local taxpayers through the local government. The biggest problem is falling land prices. If homes are falling 25-35% new sales studies for property values will reflect that. Values will need to either adjusted down or the rate of increase in valuation will be froze. Other cost to the local governments goes up, for instance, our health insurance is projected to increase 25% this year, so other parts of the budget are squeezed also. This could cause default, but I’m sure most locals would cut other programs or personnel in order to make payments.
Large cities have other problems. Many use local taxes such as income and sales taxes. Some have hotel room taxes, all subject to economic activity. These could lead to default in a slowdown.
Last, water ans sewer can be either special assessment bonds or paid by monthly rates. Either would be dependent on housing. Assessments on housing values, and rates on occupancy.
In my judgement, small and medium local governments, under 100,000 persons aren’t a big risk because most are very flexible these days. Many locals have employed best practices and they are much more efficient than the Feds and state governments. Larger munis likely have reserves that can get them through and the ability to borrow. But a long downturn could put them in a pinch. But state governments would likely legislate a way for them to stay up on payments. Thats what Michigan done for Detroit.

Posted by: jdp | Feb 16 2008 13:40 utc | 20

A wellwritten NYT piece on Credit Default Swaps – also known as toxic waste – looks like some basements at wallstreet are filled with this stuff:
Arcane Market Is Next to Face Big Credit Test

Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.
The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.
…
In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured.
But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.
As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims.
…
Commercial banks are among the biggest participants — at the end of the third quarter of 2007, the top 25 banks held credit default swaps, both as insurers and insured, worth $14 trillion, the currency office said, up $2 trillion from the previous quarter.
JPMorgan Chase, with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively.
…
There is no exchange where these insurance contracts trade, and their prices are not reported to the public. Because of this, institutions typically value them based on computer models rather than prices set by the market.
Neither are the participants overseen by regulators verifying that the parties to the transactions can meet their obligations.
The potential for problems in sizing up the financial health of buyers of these securities leads to questions about how these insurance contracts are being valued on banks’ books. A bank that has bought protection to cover its corporate bond exposure thinks it is hedged and therefore does not write off paper losses it may incur on those bond holdings. If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank’s losses would have to be reflected on its books.
…

This stuff will blow up some big banks … there is not a chance that any government action can help …

Posted by: b | Feb 17 2008 8:01 utc | 21

Yeah, everything hinges on netting and closeout, boilerplate contractual provisions intended to cut the bullshit in case one counterparty defaults. We’ll see how that holds up when the lawyers get involved.

Posted by: …—… | Feb 17 2008 14:10 utc | 22

b@21, all the more reason to attack Iran

Posted by: Cloned Poster | Feb 17 2008 14:48 utc | 23

@CP – yes, I see the danger …
@22 – the problem is that over-the-counter derivatives that make up this mess are not standardzised. They are individual contracts that all differ from each other.
They thereby can not be “netted”. Someone promissed to deliver 100 sacks of potatoes and as “a hedge” bought the right to purchase 80 sacks of apples. Now try netting that in a insolvent market where the only real things available are two sacks of rice.

Posted by: b | Feb 17 2008 15:31 utc | 24

Netting could work with individual pairs of counterparties. Where it falls down is with gigantic intertwining clusterfucks of transactions in default, which is all cases.
The worse, the better.

Posted by: …—… | Feb 17 2008 16:09 utc | 25

Congrats to the British taxpayers. You will now pay for the profits some big wigs made from Northern Rock. Britain to Nationalize Troubled Mortgage Lender.
And us Germany will pay for the IKB desaster and other local bank robbers.
The U.S. folks will mostly pay through very inflation as the US$ will plunge and maybe a bailout for Citibank or BofA which seems to be on the border (more likely already over the border) of bankcruptcy.

Posted by: b | Feb 17 2008 19:01 utc | 26

Tanta at Calculated Rsk has a superb piece today.
There are some thoughts of “debtor unions” etc. in the comments. Difficult to do, but any left leaning person should think about how the evolving catastrophy can be turned into some permanent victory.
Not that I expect such, “the left” will, like it ever does, split over this an lose the momentum.

Posted by: b | Feb 17 2008 19:57 utc | 27

AL QAEDA CAUSED THE SUBPRIME CRISIS!!!!
Also see, The Terrorists Still at Ground Zero, 7 World Trade Center, Lower Manhattan
In the subprime mortgage scam, Moody’s played a role analogous to that of Arthur Andersen in the Enron maneuvers. They provided triple-A ratings all around for junk, ten years running.
When’s the investigation? /snark

Posted by: Uncle $cam | Feb 17 2008 23:31 utc | 28

Great article, thank you!!!

Posted by: Anonymous | Feb 20 2008 22:40 utc | 29

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