Buffett's No Godfather to Bond Insurers

Updated from 11:26 a.m. EST

While Warren Buffett may be one of the savviest investors on Wall Street, his offer to struggling bond insurers proves he's no Vito Corleone: It's an offer they can refuse.

The Oracle of Omaha's offer, made public Tuesday in an interview with CNBC, is to reinsure some $800 billion in municipal bonds held by Financial Guaranty Insurance Co., MBIA(MBI Quote) and Ambac Financial(ABK Quote) -- three of the most cash-strapped bond insurers. The monoline bond insurers' struggles have caused the ratings agencies to downgrade or threaten downgrades to their pristine credit, which threatens to prompt further trouble in the broader financial markets.

Nevertheless, one of the firms -- which Buffett wouldn't name in the CNBC interview -- has already rejected the offer and the other firms are not likely to line up in support of the so-called rescue either.

The Buffett proposal fails to provide the embattled firms any relief in the more dicey securities that they insure -- including pools of mortgages and other debt called collateralized debt obligations, or CDOs -- and offers to further strip valuable revenue from safer municipal bonds from the insurers. The companies that have been on mad dash to raise fresh funds and shore up their balance sheets as rating agencies dial down their coveted triple-A ratings.

"If you're a monoline that believes that you're a going company, I really don't see why you're going to do this," said Rob Haines, a bond insurer analyst at CreditSights.

Ratings firms such as Moody's Investors Service, Standard & Poor's and Fitch Ratings have become increasingly more negative in their outlook for securities linked to mortgages. It is these securities, packaged as CDOs and asset-backed paper, that pose the most risk for causing the bond insurers pain and anguish and it's exactly those securities that Buffett is aiming to shun as he embraces the more attractive portions of insurer portfolios.

Fitch has already downgraded FGIC and Ambac from triple-A to double-A. Other financial guarantors also have seen their high ratings slashed. Ratings are important to guarantors' business because they use these scores to backstop potential losses on the securities they insure. But the agencies, expecting an increase in losses in mortgage debt originated in 2006 and early 2007, have been pushing insurers to raise more capital to protect against defaults, which has hurt investors' confidence in guarantors.

Calls to FGIC and Ambac were not immediately returned. A representative for Buffett reached at his office in Omaha, Neb. said he was unavailable for comment. Shares of MBIA were dropping 11% to $12.04. Ambac was even worse, losing 14% to $8.99.

In many ways, the Buffett plan offers to kick the insurers while they are down, but that's largely because he sees an opportunity to reap huge benefits from the distress in those companies. "Their backs are against the wall," Haines commented.

The offer proposes to take a big premium in municipal debt that has very little chance of default, while leaving the toxic debt in the hands of the insurers -- creating essentially a good insurer/bad insurer scenario. The plan does free up capital, but at the cost of taking away revenues from the company's future business. Bond insurer's provide insurance on some $2.5 trillion in debt about half of exposure represents low-risk municipal insurance for towns, city and state governments.

"Why would a reinsurer give up what is still the profitable side of the business?" Haines asked. "That's the future of the business."

Expectations are that guarantors will turn down the proposal. One source familiar with the situation says that MBIA has already rebuffed the Buffett proposal. MBIA CFO Chuck Caplin noted during the company's fourth-quarter earnings call last month that it considered reinsurance a bad option, because it didn't provide enough capital in exchange for relinquishing a portion of its business.