Warren Buffett gives the bond insurers a good kicking

Warren Buffett has offered to relieve the ailing monoline insurers of their best assets, leaving them the subprime rubbish. You've got to admire his ruthlessness. But are the monolines desperate enough to accept?

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You have to admire Warren Buffett.

He's offered to relieve the ailing monoline bond insurers of their very best assets,leaving them with all the subprime rubbish that got them into trouble in the first place. It's a viciously cut-throat offer to a group of crippled opponents, kicking them when they're down and defenceless.

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He cheerfully admits that this is capitalism, red in tooth and claw, at its finest. "I'm not doing this so that St Peter will let me in at the pearly gates. We are doing this to make money," he said.

And still the market applauds him as a hero "Buffett to the rescue!" as one Forbes headline put it.

The man has style...

Warren Buffett's offer to take all the best bits from the monoline insurers is a smart move. He has said his Berkshire Hathaway investment vehicle will put up $5bn to reinsure $800bn worth of municipal bonds currently backed by the monolines. These are bonds largely issued by local government bodies in the States to raise money for public works.

Let's recap on what's happened so far. The monolines are big insurers, who basically rent out their AAA-credit ratings to bond issuers who don't have high credit ratings. In the good old days before subprime, most of their business was taken up with insuring these municipal, or muni' bonds.

This was all fine. Although many muni' bond issuers don't have much of a credit history (and therefore find it difficult to get decent credit ratings themselves) they are ultimately backed by taxpayers, and thus pretty safe bets. Indeed, the historical default rate is less than 1%. So monolines would back the bonds; the muni issuers would benefit from getting the cheaper borrowing rates that come with a AAA-credit rating; and the monolines would get a nice fee.

Monolines: where it all went wrong

If they'd stuck to that nice little arrangement, everything would have been fine. But along came sub-prime securitisation with its promises of tasty fees and lovely, property-backed bonds that surely couldn't go wrong. The monolines piled in, but in the process, rented out their AAA-credit rating to the wrong people. Sub-prime blew up, leaving the monolines with a pile of liabilities that they now can't back up.

The big worry has been that the biggest monolines will lose their AAA ratings, with a few agencies already knocking them down a notch. If they lose their ratings, so do all the bonds they backed, which means even more writedowns for anyone holding onto them like big investment banks, for example.

Where are the munis in all this? Well, they've been hit too. But the difference between munis and sub-prime bonds, is that munis are basically AAA debt that just can't get the rating. Whereas sub-prime was junk pretending to be AAA. So the munis now look cheap. And as we all know, if there's a man who can't resist a bargain particularly in the insurance sector it's Warren Buffett.

So now Mr Buffett's offering to take responsibility for all these low-risk munis ($800bn-worth) off the three biggest monolines' (Ambac, MBIA and FGIC) hands for the princely sum of $5bn. The deal would free up around $8bn worth of capital for the bond insurers munis are low risk, but they still have to put aside some money to cover them. That would give them a bit more breathing space in their desperate dash for capital to allow them to hold onto their AAA-ratings.

"This would just eliminate one major cloud from the market," said Buffett. It'll also mean a great return for Mr Buffett. The Telegraph reports that if Ambac and MBIA were to accept the deal, Berkshire Hathaway would end up netting $3bn in premiums.

Are the monolines desperate enough to accept?

It's a smart offer. Of course, that doesn't mean they'll accept it. One has already rejected the offer. And the truth is, it does look like the kind of deal you'd only accept if you were absolutely desperate. After all, this boils down to selling your best income-producing assets so that the money can be thrown after your bad loss-making ones.

And JP Morgan estimates that if mortgage defaults continue at the current rate, the bond insurers could be looking at $41bn of losses in all. In that context, $8bn suddenly doesn't look like much money.

But as Mr Buffett might be thinking, beggars can't be choosers.' I suspect the monolines will reject this initial offer. But I wouldn't be surprised to see a deal hammered out at a later date when things inevitably continue to deteriorate in the US housing market. Eventually Mr Buffett will make them an offer they can't refuse.

My colleague Tim Bennett wrote about municipal bonds, and more importantly, how you can follow Buffett and buy into them, in the latest issue of MoneyWeek. Subscribers can read the piece online here: How to make money in municipal bonds. And if you're not already a subscriber, you can get your first three issues free - and three weeks' access to all articles on the MoneyWeek website - by clicking here: 3-week trial.

Turning to the wider markets...

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Buffett's plan gives stocks a boost

London 's FTSE 100 index

jumped 202 points to closeat 5,910, tracking an early surge on Wall Street. The broader indices were also higher. ICAP made the day's strongest gains, with fellow financials including Barclays and Old Mutual also amongst the top risers. For a full market report, see: London market close

Elsewhere in Europe, stocks also ended the day with good gains. The Paris CAC-40 was up 158 points at 4,840. And over in Frankfurt, the DAX-30 was 224 points higher, at 6,967.

On Wall Street, Buffett's proposed buyout of bond insurers prompted a rally yesterday. The Dow Jones ended the day 170 points higher, at 12,410, having earlier risen by as much as 220 points. The broader S&P 500 was 14 points higher, at 1,353. And the tech-heavy Nasdaq was 15 points higher, at 2,335.

In Asia,

the Japanese Nikkei was up 46 points, at 13,068. And the Hang Seng was 247 points higher, at 23,169, in Hong Kong.

Bradford and Bingley reveals second-half loss

Crude oil futures were flat at $92.79 this morning, and Brent spot was at $93.25 in London.

Spot gold had fallen back below the $900 mark this morning, partly due to reports of falling Indian imports, and was last trading at $897.70. Platinum was last trading at $1,890, as investors took profits on yesterday's record high of $1,965. Silver was also trading below yesterday's 27-year high, at $16.95.

In the currency markets, sterling fell to 1.9564 against the dollar this morning

ahead of the Bank of England's inflation report. The pound was at 1,3437 against the euro. And the dollar was at 0.6867 against the euro and 107.21 against the yen.

And in London this morning, Bradford & Bingley - the UK's biggest lender to landlords - slumped 16% after announcing a £35.8m loss in the second half. The mortgage bank has been forced to write down investments and sell assets at a loss as bad debts tripled

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.