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
struggling.
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
paper.
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.