Defenestrating Thoughts from the Bivouac

Yesterday, Warren Buffett offered to “buy” the municipal bond portfolio off some monoline insurers. And for some reason that I can’t figure out, the market saw this as a positive sign and went up.

Some background: monoline insurers cover bonds (principal and interest) when an issuer defaults. Municipal bonds are considered to be a low risk bonds and thus more profitable to insure. Usually bond insurers offer insurance mainly to muni bonds, but with the credit bubble, a lot of monolines took on riskier debt to make a profit.

Now, as the monolines are forced to cover bad bonds, they no longer have the capital to maintain a high rating (”AAA”). Without a AAA rating, the monolines can’t attract new business. And without new business, the monoline has no cash flow and will collapse. That, of course, is bad.

Buffett’s offer was to pick up the coverage of only the muni bonds; not any of the subprime mortgage debt. And, of course, subprime debt is the cause of the problems. So Buffett is basically saying, “Let me take your profitable business and you keep the garbage.”

Insuring muni bonds is the only profitable part of the monoline business. And if Buffett takes that over, he will basically get all the future contracts. Why? He’d be the only one with a AAA rating, because he’d have a nice portfolio of safe muni bonds.

Also consider this: for bonds, the insurance premium is paid when the bond is issued. So the monolines would have to pay Buffett to take over the muni bond liability.

Buffett himself said that he’s not being altruistic: “”When I go to St. Peter I will not present this as some act that will entitle me to get in. We’re doing this to make money.”

So why would a monoline accept this offer? Only if they were very desperate. Desperate enough to “sell off” their most valuable asset in the hope of delaying rating downgrades until they to fix up their asset to liability ratio. It would be unlikely to work, so this is really the last resort “nuclear” option to save themselves.

Buffett knows that the monolines are in bad enough shape that they would consider the nuclear option. So he made the offer.

So given this, why did the market go up?