Buffett Watch

Why California Isn't Buying Warren Buffett's Bond Insurance

California Attorney General Bill Lockyer formally announces a lawsuit against a Sempra Energy affiliate, alleging that its traders manipulated electricity prices during the state's 2000-01 energy crisis, at a news conference in Sacramento, Calif., Wednesday, Nov. 16, 2005. (AP Photo/Steve Yeater)
Steve Yeater

Warren Buffett is getting two very different messages from the capitals of two of the nation's most influential states: New York and California.

Late last year, with the encouragement of New York's top insurance regulator Eric Dinallo, Buffett's Berkshire Hathaway launched a new bond insurer.  Dinallo asked Berkshire to get into the game because he was worried that the financial troubles facing established bond insurers like Ambac and MBIA would make it harder for cities and towns to find willing buyers for their municipal bonds.

If bond buyers can't trust the insurance company backing the bonds, they'll demand higher yields to compensate for the increased risk they won't get their money back.  Higher yields may be good for the buyers, but they increase the cost of borrowing money for perpetually cash-strapped municipalities.

Buffett says he'd been thinking about getting into bond insurance for years, but didn't because he thought the scramble to write new policies had driven down prices so low they didn't cover the risk being taken on by the insurers.

With Ambac and MBIA facing big losses in the wake of the sub-prime collapse, Buffett sees an opportunity to use Berkshire's strong financial position to back muni bonds, at what he sees as an appropriate (higher) price.

California's Treasurer Bill Lockyer sees it differently.  He sees decades of history in which almost no muni bonds have fallen victim to a default.  (MBIA and Ambac got in trouble not because they guaranteed munis, but because they branched into riskier areas, backing bundles of other loans, including those notorious sub-primes.)

Lockyer argues that the main reason muni bond buyers think insurance is needed at all in most cases is because the big credit ratings agencies don't evaluate state and local government debt the same way as corporate debt, artificially lowering credit ratings for those governments.

He's now proposing that some big California pension funds start their own muni bond insurer to compete with Berkshire, and tells Bloomberg and Reuters he won't do any business with Buffett, accusing Berkshire of supporting the two-tiered credit rating system.

While not exactly endorsing the corporate-government split, Berkshire's top insurance executive Ajit Jain did acknowledge in prepared testimony for a hearing by the House Financial Services Committee that "if the rating agencies level the playing field in terms of how they rate municipal versus corporate obligations, there will be little need for a financial guaranty insurance marketplace as we know it, because much municipal debt on a stand alone basis may not require the enhancement of the insurance to manage the costs of that debt."

That's one of the reasons Jain said he's "very concerned about the long-term viability of this business (bond insurance) in general and for us in particular."

Perhaps the bigger disagreement between Berkshire and California is on how risky muni bonds really are, an assessment that helps determine the 'right' price for bond insurance.

In his testimony, Jain argued against the 'no risk' view of muni bonds"

"There is hardly a sufficient history to conclude that there is a zero chance of loss in this business, although that is the assessment that gets reflected in the pricing.  While there have been few municipal defaults in the past fifty years, Jefferson County, Alabama and Vajello, California, both having received publicity lately about possible defaults on their debt obligations, could just be the tip of the iceberg as municipalities are coming under increasingly unfavorable economic conditions, including reduced real-estate and sales-generated tax revenues and underfunded future pension and healthcare costs."

If California does gets its way, and the credit agencies do change their ratings system for government debt, Berkshire's "tip-toe" into the bond insurance business may not last all that long, leaving the state a clearer field to take on the very small, but potentially catastrophic, risk of widespread muni bond defaults.

Current Berkshire price:

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