Buffett's Not Insurers' Only Hope

Warren Buffett is offering monoline bond insurers just enough of a financial lifeline to hang themselves, but a handful of alternatives to his so-called bailout may provide financial guarantors and the broader market more attractive options.

Buffett's plan proposes to reinsure some $800 billion of municipal bonds backed by Financial Guaranty Insurance Co., Ambac FinancialABK and MBIAMBI, three of the more cash-strapped insurance entities.

The proposal will have the effect of siphoning away valuable municipal bond revenue from the companies, while offering comparatively little relief in the form of fresh cash to stave off future losses in some of the riskier, more esoteric debt that has bedeviled them.

In essence, the plan would quietly place in Buffett's well-poised hands the crown jewel of the bond insurer business, while leaving it with the toxic waste of mortgage debt that could be the companies' undoing.

Moreover, guarantors still would be at risk of being stripped of their high credit ratings, which would impinge on their ability to secure business in the future. Guarantors such as FGIC and Ambac have already been downgraded from triple-A to double-A, while MBIA is under review for a possible downgrade.

Other bailout plans, including one being orchestrated by New York state Insurance Superintendent Eric Dinallo, would see cash-strapped investment banks CitigroupC, Merrill Lynch MER and UBSUBS provide as much as $15 billion from their own depleted balance sheets to protect guarantors against losses in collateralized debt obligations.

These banks have been among the biggest underwriters of CDOs over the past 18 months. Two bank consortia also have proposed separate rescues of Ambac and FGIC.

Most of the plans, however, fail to address the heart of the bond insurers' -- and in many ways, Wall Street's -- crisis: a wave of defaults in the home mortgage market.

Some Wall Street executives, including Edward Stefalin, partner at GSC Group in New York, suggest that banks and monolines attack the root cause. He proposes the two groups form a consortium or fund through which they commit to purchasing the poor-performing loans underlying the residential mortgage-backed securities that have been vexing Wall Street firms.

"The consortium would then donate those properties to the government (federal or state) and receive a tax deduction or just hold and rent [them] out over time," notes Stefalin. He estimates that around $50 billion and as much as $100 billion might be needed to execute the initiative.

Stefalin's proposal would have the effect of extracting the troubled debt from the CDO packages, while saving the rest of the securities in the pool. That works because troubled loans can be extracted from CDO pools, which can consist of a mix of debt, including student and mortgage loans and other receivables, without being replaced by the servicer, Stefalin says.

For the ratings agencies such as Moody's Investors Service, Standard & Poor's and Fitch Ratings, residential mortgage-backed securities originated in 2006 and the first half of 2007 pose the biggest problems for bond insurers, because of their increasing likelihood of default. Bigger projected losses are compelling the agencies to require firms such as MBIA, Ambac and others to raise more money in case of losses.

Stefalin notes that the absolute losses by banks, brokers and monoline insurers are magnified by 20 to 30 times because of derivatives used to enhance gains, but could be stemmed by going after the physical assets.

"Thus if they all joined and attacked the root of the problem, they would clear this up in no time and the financial system would snap back," Stefalin speculates. A positive consequence of the plan, he adds, is that the federal and state governments also would have free housing stock to give to low- to middle-income families.