Why insure munis when you can buy them instead?

June 9, 2009

My fabulous new colleague Agnes Crane notes something interesting: even as he cools on the idea of selling municipal bond insurance, Warren Buffett has been loading up on municipal bonds. Why would Buffett want to take municipal credit risk in the bond market, but not want to take the same credit risk by selling insurance? I think there are at least five reasons:

  1. Insurance, by its nature, is highly leveraged: the amount of capital that Buffett would have to set aside were he to insure $1 million of municipal bonds is tiny — and possibly even zero, at the margin. But leverage is not the kind of thing that Berkshire’s investors want to see right now. They’d prefer him to just spend $1 million of his cash on municipal bonds — at least that way you can’t lose more than you’ve spent.
  2. Default risk goes up when the issuer is insured — it’s the moral-hazard problem. Buffett might well be interested in buying uninsured bonds because he knows that municipalities will be hesitant to default on their own citizens. But if a bond is insured, the municipality knows that its citizens will still get paid out by insurers, and that makes it easier to take the decision to default.
  3. It’s easier to pick and choose credits if you’re buying in the secondary market than if you’ve set up shop as a bond insurer: a bond investor will shun most credits, but it looks pretty bad when an insurer says no to most credits.
  4. An insured bond is a credit risk all the way to maturity, while Buffett can sell his munis as easily as he bought them. Maybe this is just a trading play, rather than a buy-and-hold investment.
  5. Most importantly, if Buffett has been buying up munis cheap in the secondary market, he’s probably getting much higher yields than he could ever charge in the primary market as an insurer. He might be able to charge a percentage point or two to insure an issuer against default, but I’m sure he can find munis for sale at spreads much wider than that.

Given all these reasons to buy bonds rather than insure them, I do wonder what’s going to happen to the monoline market. Historically, it’s been a license to print money — but it might be a very long time before it re-emerges.

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