Buffet Offers To Re-Insure Munis; Not CDO's

A: This is important and market futures are jumping a bit since this conference call with Warren Buffet. Buffet has offered the three major bond insurers to re-insure up to $800 Billion worth of municipal bonds. One major concern on wall street was that if the bond insurers get downgraded, the innocent victim will be the municipal bond market and that will rattle financial markets globally; hence the all-in effort to stave off credit downgrades. Now, Buffet gets in the mix and offers to re-insure these bonds and prevent any disruption of the muni market if downgrades come. The problem is, 1 of the 3 bond insurers already rejected the offer and the offer does NOT include any bailout for complex CDO's, where the problems are in the first place.

First the news. According to CNN Money:

The billionaire's Berkshire Hathaway (BRKA, Fortune 500) approached the three largest bond insurers last week, offering to insure about $800 billion in tax-exempt bonds, Buffett told CNBC in a televised interview.

"This would just eliminate one major cloud from the market," said Buffett.

Thats the good part, as I noted yesterday in my post on failed student loan bond auctions that disruptions in the muni market is what is really scaring wall street. So, the street is taking comfort that there is one backup solution on the table to re-insure a helluva lot of muni bonds! Buffet said his deal is on the table for 30 days! So we have like 23 days left, since the offer was sent in last week.

Now the bad news. Buffet's offer does NOT cover the complex financial instruments that have lost so much value as the national housing slump caused rising delinquencies for subprime borrowers. That is where the real problem is. These bond insurers have offered insurance on billions of CDO's (collaterilized debt obligations), and other types of residential mortgage backed securities to the likes of Citigroup, Merrill, Morgan Stanley, Wachovia, Washington Mutual, etc.. These complicated structures basically took subprime loans, bundled them up into one big pool, made a bond out of it backed by the mortgages, and then sliced & diced the bond up into different tranches of risk (AAA, AA, A, BBB, BB, etc) and sold them off to investors; here is a breakdown of how mortgage backed securities work and why we are in such trouble. All was fine & dandy as long as housing appreciated, payments were made, and the secondary market where these instruments trade was functional. It was when housing turned down, defaults rose, and the secondary market for these trades dried up leaving holders of this toxic waste with no place to sell at a desirable price. Hence, the write-downs.

They turned chicken shit into chicken salad and sold it to investors who then took out insurance on these credit products should they go sour. Well they did. And now the bond insurers have tons of claims that will need to be paid out; and guess what, we're not sure if they have the capital!

So, the financial institutions will have to book more write-downs. Buffet won't even touch the CDO's that were insured by Ambac, MBIA, and other insurers. It's way too complicated for Buffet, he doesn't know how deep the losses could go, and he doesn't understand the complexity of the products themselves. That tells you something. Which leads me to the final point.

If Buffet will backup and re-insure the muni's on any downgrade, all we need to do is fix the problem with the CDO's, that Buffet won't touch. Easier said then done, but at least we have a bit more clarity right now, although without any concrete solution. This will add some degree of confidence to the markets.