Warren Buffett, Bond Insurer

I’m fascinated by the news

that Warren Buffett is starting up a new bond insurer. On the one hand,

it makes perfect sense: he’s an expert in insurance, he already has a

triple-A credit rating, and his competitors in the market are all


But on the other hand, this is a declining market. This time

last week I posted a blog

entry headlined “Munis Back Away From Ratings-Agency

Domination,” which celebrated the fact that city and state issuers were

increasingly wondering whether bond insurance was worth their while.

After all, in an efficient market, bond insurance shouldn’t

really exist as a standalone product. That’s because it already

exists, in the form of tradeable credit risk. Someone buying an

uninsured municipal bond is essentially taking exactly the same default

risk as a bond insurer who insures that bond. And in a market with

thousands of bond investors, it’s pretty ridiculous to assume that one

specific bond insurer will always have a greater appetite for that

default risk than the marginal bond investor would.

Now  historically, there’s been another reason why

bond insurance exists, and that’s credit ratings. There are some

investors who will invest only in AAA-rated securities, and who will

pay through the nose for the privilege of being able to do so. They

don’t want to take default risk, and they’re happy to pay bond insurers

to take that default risk for them.

Well, two things have changed of late. The first is that

investors don’t care as much as they used to about AAA ratings, ever

since a bunch of AAA-rated securities started defaulting not long after

they were issued. If the ratings agencies can’t be trusted to be right

on the subject of how rock-solid a triple-A rating really is, then

there’s much less justification for paying a premium for AAA-rated


The second development is the explosion of the credit default

swap (CDS) market. There’s now a very liquid market in default risk,

which means that again investors don’t need to rely on bond insurers to

take their default risk from them. Of course, they still need to worry

about counterparty risk, but let’s say that they restrict their CDS

counterparties to the known bond insurers. In that case, their

counterparty risk is no greater than if they’d bought a wrapped bond.

As ACA has proven, counterparty risk is hardly unknown in the

bond-insurance market.

What’s more, Buffett seems to be saying that he’s going to

charge more for bond insurance not only than the CDS market, but even

than his competitors in the bond-insurance industry.

Mr. Buffett said his company will charge more than his

competitors because of what he calls the “moral hazard” inherent in

bond insurance. That is, governments that have insurance could take

advantage of it by borrowing and spending far beyond their means to

repay the debt, and simply default, leaving the insurer on the hook.

I think this is a polite way of saying that he will charge

more than his competitors because his AAA is real, while their AAAs are

looking increasingly fictional. Moral hazard in the muni bond-insurance

market is a bit of a non-issue: if a democratically-elected

municipality slides into default, it’s not going to be because its

bonds are insured.

So I’ll be surprised, then, if Berkshire Hathaway Assurance

Corp becomes a major business. To be sure, it might become a bigger

business than Dairy

Queen, and Buffett seems to be very happy owning Dairy Queen.

But I do have a feeling that the basic bond-insurance business model is

probably doomed, even if (or, rather, because) it will continue to be

very profitable until its demise.

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