Buffett Plan Beats a Bailout

Warren Buffett's latest proposal for the troubled bond insurance industry is no help to MBIA(MBI Quote) and Ambac (ABK Quote), but it could be the best free market solution for everyone else.

On Tuesday, the legendary investor and CEO of Berkshire Hathaway (BRKA Quote) disclosed a letter he sent earlier this month to the two largest bond insurers, as well as privately held Financial Guaranty Insurance, offering a second level of insurance on up to $800 billion of the municipal bond underwritings at the companies.

Buffett wants no part of the structured finance underwritings that have plunged the industry into turmoil in recent months amid a rash of defaults in collateralized debt obligations, or CDOs, tied to risky mortgage loans. He's offering to take over the most stable part of the bond insurance business, and leave the bond insurers to deal with the rest.

"This is probably the most palatable solution that the private market can come up with for the problems with the bond insurers," says T.J. Marta, fixed income strategist with RBC Capital Markets. "No one can expect a private party to take on these CDO exposures. That simply would not be rational. Also, the people who got involved in these CDOs deserve whatever problems are in store for them."

The S&P 500 and other major stock averages rallied on news of Buffett's offer Tuesday, but shares of MBIA and Ambac dropped more than 15%. Major finance houses like Citigroup (C Quote) and Bank of America (BAC Quote) climbed more than 1%.

The Oracle of Omaha told CNBC that one company already has declined his offer, and most observers think the other two will shortly follow suit. (Ambac later on Wednesday said it had rebuffed Buffett, while sources told TheStreet.com MBIA also declined the offer.) But in a dramatic departure from his practice of negotiating deals in private, Buffett took his offer to the media and the insurance regulators because he knows his plan offers a workable solution to some of the problems that loom for the financial markets as a result of missteps by the bond insurers.

"It would solve [those problems] in one stroke of a pen,'' Buffett said on CNBC. He didn't respond to an inquiry from TheStreet.com.

One recipient of Buffett's proposal was Eric Dinallo, the New York Insurance Superintendent. Dinallo has taken the lead among regulators in trying to find a solution to the bond insurance debacle. The major bond insurers have veered away from their traditional business of insuring municipal bonds into the riskier game of underwriting structured finance securities. Now that investors have lost faith in structured finance offerings, the bond insurers are losing the pristine credit ratings on which their business depends.

If the bond insurers fail, the credit crunch that has wreaked havoc on global financial markets in recent months could worsen, and Dinallo has been working on a way to prevent that.

"I am pleased that this provides one option to protect municipal bond issuers and investors," Dinallo said of Buffett's proposal in a statement.

Bond insurance critic Bill Ackman, who manages hedge fund Pershing Square Capital and is short MBIA and Ambac, said at a conference on Tuesday that when the bond insurers are downgraded, some of the $1.6 trillion in municipal debt that is backed by bond insurers could also be downgraded. If that happens, Ackman said, all the money market mutual funds and other institutions that hold that debt could be forced to dump their holdings, since they're required by federal regulators to maintain high credit ratings for a large majority of their holdings.

"The result could be a massive selling of securities and in light of the supply-demand imbalance that would result, you could have big losses taken by money market mutual funds," says Ackman. "That does pose a real risk to the market."