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:
- 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.
- 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.
- 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.
- 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.
- 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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4 comments so far
You missed one huge advantage - absolutely no need to deal with the ratings agencies. The agencies would need to sign off on any monoline deal. Secondary market purchases side-step that process entirely. That said, not sure that BH (big Moody’s shareholder) would be thinking in these terms. Speaking as a semi-professional monoline water-carrier, I’d say you’re onto something, not least because of the amount of time it’s taking Macquarie and Citadel to start up their bond insurer. That said, I’m not sure you can assume that because a huge, diversified and savvy fixed-income investor (among other, um sidelines) can see some value in deeply-discounted secondary market purchases there’s no problem for thinly-traded and little-understood public finance credits in getting access to market.
- Posted by Gari N. CorpOn your point #2, Warren wrote about the moral risk in his 2008 letter to share holders, including this:
- Posted by John Omeara“When faced with large revenue shortfalls, communities that have all of their bonds insured will be
more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured
bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be
highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?”.
I think Warren will leave it to the Federal government to insure municipalities instead of stepping in front of that cannon.
I see a flaw in Warren’s argument about the higher risk of default on insured munis. The long term consequences of a municipality default are the same whether the bonds are insured or not. Its ratings go to D. It’s future access to capital dries up overnight. And while that may be OK short term, it is not sustainable long term. Unlike corporations, most municipalites simply cannot shut down. They need continued access to credit execute their mandate. Bailing on their bonds has the same long term catastrophic effect whether they are insured or not.
- Posted by joseph victorGood post, Felix. The capital charges to hold an investment grade muni on the balance sheet is minuscule compared the capital needed to guarantee them.
Though this is a derivative of your point #3, he gets better diversification, and he gets to choose from a wider field whose credit risk he takes on.
- Posted by David Merkel