Wednesday, March 5, 2008

Buffett's New Elephant: Why Muni's Have Buffett So Exicted

For years, Berkshire Hathaway's gigantic cash pile has been growing at a faster rate than attractive opporutnities available to Warren Buffett to invest in. Buffett has made it no secret that he would welcome a huge "elephant" type acquisition for Berkshire where he could deploy ten billion dollars or more of Berkshire's cash. Recently, Buffett has found pockets of opportunity to plunk down a few billion here and there – the Marmon deal for $4.5 billion and a few billion for nearly 20% of railroad operator Burlington Northern. Yet as Berkshire's size has mushroomed, the days when Buffett could chunk nearly 20% of Berkshire's book value into Coke are rare.

It turns that an elephant of an opportunity may lie in the same field that catapulted Buffett and Berkshire from the multi-million club to the multi-billion club – insurance. Late last year, Buffett announced that Berkshire Hathaway had agreed to deal terms with the state of New York to set up shop as a municipal bond insurer. Initially this was a small deal for Berkshire, but the hope was to gradually expand the newly set up Berkshire Hathaway Assurance Corp (BHAC) bond insurance operations across other states.

It didn't take long for Buffett to up the stakes, as he is apt to do when great opportunities exist. Earlier this week, Buffett announced that he had offered to assume liability of the municipal bond insurance operations of MBIA, Ambac and FGIC Corp. In a letter to MBIA, Ajit Jain, President of BH Reinsurance, stated that BHAC's capitalization would be increased to five billion dollars and that "we would undertake not to reduce BHAC's assets by dividends, fees, etc., for a minimum period of ten years." Jain ended the letter by saying "We would be prepared to complete this transaction within the next five days." A closer look into the municipal bond industry reveals why Berkshire is so intrigued by this rare opportunity.

A. Huge Opportunity

According to a recent article published in the Wall Street Journal, the current municipal bond market is approximately $2.6 trillion. Roughly half of this amount is insured by MBIA, Ambac, FGIC, and a few other smaller names. The Wall Street Journal recently cited that in some cases, municipal issuers have paid as much as $2.3 billion a year in premiums to just insure their bonds. And Buffett's offer was on approximately $800 billion or so in municipal bonds. Even for Berkshire, this is serious money.

B. Virtually risk free instruments

Municipal bonds are issued to finance government infrastructure and are often collateralized by the tax revenues of the issuing entity. Since taxes are going away anytime soon, municipal bonds don't default much. According to the article, the state of California, one of largest issuers of municipal bonds, the state requires that tax dollars go first to education and second to pay off bond debt. To wrap your head around why default is unlikely, California's estimated $100 billion in annual tax revenues should do a good job of keeping them from default. Since 1970, municipal bonds rated double B have a cumulative average default rate of 1.74%. The equivalent default rate for double B corporate bonds is – 29.93%.

C. Favorable Economics

Before this current credit crisis, a state like California with its stable tax revenues would benefit very little from having bond insurance. Deciding whether or not to insure bonds is a simple exercise in cost benefit analysis. For example, if a state issuing municipal bonds is looking at paying 4% with insurance versus say 4.75% without insurance and the insurance premium is 50 basis points, then it makes sense to insure. The recent bond-insurer crisis has created a situation whereby even rock-solid municipal bonds are finding it increasingly expensive to fund much needed infrastructure projects. And not all states are sitting flush like California. Typically bond insurers were charging about 30% of the interest savings an issuer would get. So, if you could reduce your bond rate by 0.50% via insurance, the typical premium would be about 30% of that, or 0.15%. Those days are gone. Recently insurers are charging 80% to 90% of the savings. And with investors traumatized by the liquidity crunch, municipal issuers have to rely on bond insurance even with the higher rates. Enter Berkshire Hathaway to seize the day.

D. Competitive Advantage

Here, the case is glaringly obvious. Berkshire arguably boasts one of strongest balance sheets of any company in the world. Its triple-A credit rating is virtually assured. Any municipal issuer that decides to insure with BHAC will guarantee itself a triple-A. In today's rocky credit environment, that implicit guarantee is worth a lot – and Buffett knows it. As a result, BHAC will be able to command higher premiums. And if, as I suspect will be the case, Berkshire will be the insurer of choice in each state that it decides to enter. And since just about all other bond insurers are desperately seeking to raise additional capital, Berkshire will have virtually no initial competition.

So when you add A, B, C, and D, you find an investment opportunity that is vintage Buffett. This deal offers an excellent model for all investors, both individual and professional, to emulate. Look for companies that offer durable competitive advantages, long-term growth opportunities with minimal downside, and selling at very favorable prices. And then when you find them, don't hesitate to back up the truck and load up.

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