Warren Buffett's latest proposal for the troubled bond insurance industry is no help to

MBIA

(MBI) - Get MBIA Inc. Report

and

Ambac

( ABK), but it could be the best free market solution for everyone else.

On Tuesday, the legendary investor and CEO of

Berkshire Hathaway

( BRKA) 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) - Get Citigroup Inc. Report

and

Bank of America

(BAC) - Get Bank of America Corp Report

climbed more than 1%.

The Oracle of Omaha told

CNBC

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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."

"The money market funds are the area where there would be the most concern about liquidity as a result of credit downgrades at the bond insurers," says Gavin Murphy, national editor with

The Bond Buyer

.

Bond insurers take upfront fees from issuers in return for their guarantees to pay the bondholder interest and principal in the event of default. But they don't recognize all the revenue right away for accounting purposes. They recognize it over the life of the bond, and they record the unrecognized income on their balance sheet as unearned premium reserves.

Berkshire's brand new municipal bond insurance outfit is offering to shoulder $800 billion in municipal bond liabilities at the three companies in return for a cash payment of 1.5 times their unearned premium reserve -- a rate that he said is a competitive price in the current market. He pledged to put up $5 billion in capital reserves for the business.

Meanwhile, he will allow the companies to accept his firm offer, but shop around over the next 30 days for a better one. If they find a deal more to their liking, the companies could back out of the Buffett offer for a small breakup fee.

Many of the municipal bonds backed by the bond insurers are already trading as if they have no insurance. If Buffett's proposal were accepted, Ackman said those bonds would immediately trade like a Triple-A rated security.

"They will appreciate in value, and the money market mutual funds will get a huge benefit," said Ackman. "There will be no dumping of those securities, so you completely eliminate the systemic risk associated with this."

Meanwhile, Buffett pointed out that since municipal bonds are typically longer-term obligations than structured finance securities, the municipal bond policy holders will effectively be pushed to the back of the line if the bond insurers are hit with a wave of claims on CDOs.

"We'll move them up to the front of the line," Buffett said, though he acknowledged that Berkshire was not making the offer out of altruistic impulses. "When I go to St. Peter, I will not present this as some act that will entitle me to get in. We're doing this to make money."

Ackman said that Buffett's offer amounted to calling the bond insurers' bluff.

"The bond insurers have said they're not going to end up taking material losses on all this structured stuff," Ackman said. "They say all of these market-to-market losses they're taking in the billions of dollars are going to revert to zero over time. Buffet is saying that if that's true then they can take the municipal risk off their books and everything that's left can be distributed to shareholders as profit."