The New York Times has an approving story, and the Financial Times a more neutral one, on the fact that New York state superintendent of insurance Eric Dinallo called Berkshire Hathaway’s insurance chief, Ajit Jain, and urged him to enter the municipal bond guarantee business. The license was issued in record time, a bit more than a month.
What’s not to like about this story? Well, the timing is terrible, if you care about the health of the bond markets.
The existing bond guarantors, led by MBIA and Ambac, are on the ropes thanks to misguided entreperneurship leading them from safe and profitable municipal guarantees into risky areas well beyond their balance sheet capacity, such as credit enhancement of securitized mortgages. While the AAA rated guarantors may have ultimately been unable to keep their ratings, the timing of the Berkshire announcement was another nail in their coffins. I had written them off, but was astonished that private equity firm Warburg Pincus was willing to invest as much as $1 billion in MBIA despite its awful prospects. That said to me that the firms could perhaps still be salvaged.
As we and others have said, a downgrade of the bond guarantors will have nasty knock-on effects. The rating agencies will have to work through various issues, but it will most certainly kick a lot of lower-rated tranches out of investment grade into junk. One can argue that the formal downgrade shouldn’t make a difference, but it does because many investors have all the non-investment-grade holdings they are allowed by charter or statue, usually in the form of private equity or hedge fund investments. Thus, the newly downgraded paper would have to be sold. This stuff isn’t liquid even under the best of circumstances, and with so much coming on the market at once, it would sell for dreadful prices, or not at all.
Berkhire is going to cream off the best part of the guarantee market, the muni bonds, and his presence as a competitor means he can’t be fantasized about as a possible rescuer of any of the failing firms, and will deter any other chumps against stepping forward a la Warburg Pincus to shore up one of the guarantors.
So Dinallo’s act to help his constituents a service may in the end do a lot of damage to the bond market as a whole. The jury is out until we see how bad the unravelling of the bond guarantors turns out to be.
