The Wall Street Journal-20080213-The Other --36-1 Trillion

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The Other $1 Trillion

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Say what you will about Warren Buffett, he knows how to make money. And one of his investment axioms goes: Be brave when others are fearful, and fearful when others are brave. But his offer yesterday to wade into the bond-insurance market was only half-brave, so it's worth paying attention to where he thinks the risks lie.

Mr. Buffett went on TV to announce that he had offered to reinsure up to $800 billion of municipal bonds currently underwritten by the so-called monoline bond insurers. These companies -- MBIA, Ambac and Financial Guarantee Insurance Co. -- collect premiums to guarantee that bond issuers will make their interest and principal payments. For many years, they focused on bonds issued by state and local governments, and since these entities rarely ever default, it was a good business. But more recently, some have waded into insuring privately issued bonds. Since 2001, the industry has insured more than $1 trillion in asset-backed securities, including mortgage-backed securities and collateralized debt obligations.

You can see where this is going. In the wake of the subprime debacle, this safe, profitable industry didn't look that safe any more. Who knows -- these insurance companies might even have to pay out some claims. Some of them were put on watch for credit-rating downgrades, a possibility that would undermine their ability to attract business. In effect, the business model here is that the insurers loan out their triple-A ratings to the borrowers, thus lowering the borrowers' interest payments, and in return they charge a fee. If the bond insurers' own credit rating isn't stellar, however, they have nothing to offer their customers.

This in turn has raised the specter of "systemic risk." The argument goes that if the bond insurers are downgraded across the board, the bonds they've insured go south too, causing writeoffs and another cascade of financial-industry losses. Partly motivated by this fear, New York state's hyperactive insurance regulator, Eric Dinallo, has been beating the bushes looking for rescue capital for the bond insurers. This newspaper reported that he told a group of bankers last month that, if the bond insurers blew up, Wall Street would get the blame for sinking "Main Street," so they'd better find some cash. Mr. Dinallo also invited Mr. Buffett to get into the bond insurance business.

But the notion that a spare billion or two for the "monolines" could forestall many billions more in writedowns never made any sense. Bond insurers have nothing to do besides collect premiums unless the bond goes into default. That's why the calculating Mr. Buffett only wants to reinsure the municipal business, which is pretty much all premiums and no claims. It's the other $1 trillion in exposure -- to asset- backed securities and such -- that is the big problem. So to sell off the sound part of the business to Mr. Buffett would leave the bond insurers with only the riskiest parts of their portfolios -- and they'd be paying Mr. Buffett a cut of their premiums for the privilege.

This explains why the bond insurers tanked yesterday even as the broad market rallied. Mr. Buffett's offer demonstrated that the problem facing the bond insurers is both bigger and smaller than some people thought. Bigger, because no one really wants to insure asset- backed securities that will almost certainly be under pressure going forward. And a few billion dollars in capital won't be nearly enough to make a dent in the $1 trillion in exposure that the bond insurers have to the asset-backed market. But smaller, too, because the rest of the bonds, which are good risks, won't default merely because the insurers hit a rough patch.

Like any good insurance salesman, Mr. Buffett wants nothing to do with the riskiest policies, which makes it more likely that the bond insurers will be stuck with them. Hence the sell-off of the insurers' stocks. Who wants to be brave where even Mr. Buffett is fearful?