Emotional Rescue

Story Highlights:

• Warren Buffett is offering to reinsure up to $800 billion of municipal bonds insured by MBIA, AMBAC, and FGIC.
• One insurer has already turned down the offer, signaling the bond insurance firms aren't in dire need of reinsurance for municipal bonds.
• While it's hard to know how this will play out, Buffett's offer could temporarily soothe nervous psyches.

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The big news today was Warren Buffett's offer to reinsure up to $800 billion in underlying municipal bond debt insured by the three largest bond insurers. Given that muni debt is generally not a risky part of bond insurers' portfolios and the least in need of reinsurance, it's very unlikely that any of them will take him up on the offer. One is reported to have already declined.

But a number of media stories today see it differently, calling the offer a "rescue."

Warren Buffett to the Rescue
By Paul R. La Monica, CNNMoney.com
https://money.cnn.com/2008/02/12/markets/morningbuzz/index.htm?postversion=2008021210

Buffett Bailing out Bond Insurers
By Carl Gutierrez, Forbes.com

Recall that insuring muni bonds is the bread and butter for bond insurers and has been highly profitable with little default risk over time. Where the bond insurers got in trouble was in extending beyond their historical boundaries and insuring CDOs and securitized mortgage debt. It's the CDOs and mortgage debt which is now causing all the turmoil in their portfolios.

Buffett has recently started his own bond insurance firm, catering exclusively to the core muni business, and filling the gap created by struggling bond insurers. In many ways, Buffett's offer could simply be to take market share now rather than over time—not a bad business move. Under the deal, Berkshire would take in $6 billion worth of so-called unearned premiums—money the insurers have collected from municipal policyholders but haven't recognized as revenue or paid in claims—plus a $3 billion fee. In essence, Berkshire is asking for a premium payment equal to 150% of unearned premium reserves which might be seen by bond insurers as excessive. But hey, it doesn't hurt to ask!

There is always the chance one of the insurers becomes desperate enough for capital that it's willing to sell off what may be the only profitable business it has left. But should a bond insurer be interested in re-insuring its muni bonds, Buffett isn't the only option—other insurance firms would likely jump at the chance. It's the reinsuring of CDOs and mortgage debt that no one's anxious to undertake.

This isn't a "rescue"—Buffett isn't making this offer out of the kindness of his heart. It's simply business as usual, with little downside we can see for Buffett. Plus, he isn't swooping in with anything novel. It's just the size and timing of his offer that's making headlines.

But, if the market wants to call this a rescue, so be it.

Remember, corrections, like the one we're likely currently in, are driven by psychology, not fundamentals. In order to move past our correction psychology, there will need to be some sense that we've somehow been "rescued" from the credit crisis, or there's been some other deus ex machina that helps investors realize the "American Contagion," like the Asian Contagion and Russian Ruble crisis in 1997 and 1998, just isn't big enough to tank global markets long-term.