Buffett Into Municipal Bonds Market

Image: Wes Duvall

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This article appears in the March 2008 issue of Condé Nast Portfolio. Please visit the site on Tuesday, February 19, for the full contents of the issue.

In a crisis, the guy with the cash gets the call. Late last year, Eric Dinallo, New York State's top insurance regulator, picked up the phone and persuaded Warren Buffett's company to rescue the municipal-bond world.

The normally staid business of municipal bonds was on the verge of panic. Dinallo hoped that Buffett and his gold-plated name could calm things down. The credit crunch that has consumed the real estate and banking worlds is now threatening $2.6 trillion worth of municipal bonds, which help pay for everything from bridges and tunnels to hospitals and schools. (See what some recent bonds have purchased.) Two-thirds of those bonds are owned by retail investors, many of whom want and need the sort of safety that's supposed to go along with investing in government debt. Regulators like Dinallo fear that a panic would crimp the ability of state and local governments to raise money, leading to service cutbacks and canceled community-improvement projects.

The problem isn't with the muni bonds themselves but with the insurance companies that guarantee them. These bond insurers—such companies as MBIA and Ambac—are supposed to ensure that the bonds are safe. Trouble is, the insurers themselves are in crisis. This makes it clear that the entire business of muni-bond insurance is a giant taxpayer rip-off.

In theory, bond insurance lowers the cost of borrowing money. It's not unlike having your mother-in-law co-sign your mortgage: With her good credit alongside yours, the interest rate you pay will most likely drop. Let's say that Walla Walla, Washington, wants to build a dam. The rating agencies—Moody's, Standard & Poor's, and Fitch—assign Walla Walla a credit rating that determines how risky an investment the city is and, therefore, how high its interest rate should be. Assume Walla Walla's rating corresponds to a 5 percent interest rate in the market. If the city buys bond insurance, however, its bond becomes triple-A, reducing its interest rate to 4.75 percent—good for Walla Walla, which can keep its water at bay, and good for local taxpayers, who won't have to pay as much to protect themselves from it.

The business has also been very good for insurers. Until last year, bond insurers ranked among the most profitable companies in the world, with Ambac having the highest operating profit margins of any firm in the S&P 500. But then competition rushed in. In an effort to make more money, bond insurers made a terrible mistake. They branched out beyond their core business to invest in all sorts of exotic mortgage securities and other structured finance products. This has turned out to be the equivalent of insuring your brother-in-law Robbie for his sure thing involving that email from Nigerian royalty. As the bond insurers' deals have inevitably soured, the companies and their credit ratings have come under pressure and their stock prices have been tanking. Indeed, in January, Fitch stripped Ambac of its triple-A rating, which is tantamount to crushing its business model. If the bond insurers go out of business, it could cause widespread devastation. On the other side of these firms' trades are banks, which could suffer losses if the insurers don't make good.

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