February 12, 2008 12:11PM

Reality Check on the Buffett Bounce

By Elizabeth MacDonald

The market rallied on Tuesday on the news that Buffett is stepping in to reinsure up to $800bn in municipal bonds at the beleaguered bond insurers.

But it seems like someone’s reality check has bounced here. Read behind the news. This is not Buffett the white knight, he’s not taking on the bond insurers’ liabilities–he’s selling reinsurance to the bond insurers, to make money on a pretty safe business.

Buffett is basically selling a second level of insurance to the severely damaged bond insurers, MBIA, Ambac and FGIC. Under the deal, Berkshire would stand to collect a hefty 150% premium of the companies’ unearned premium reserves over the life of the bonds. The bond insurers have taken massive writedowns for insuring all sorts of bad securities backed by shoddy loans created in the subprime crisis.

The market is reacting positively because Buffett effectively would sell to the bond insurers, who are fast losing their Triple A status, his own more stellar Triple A credit rating (a Triple A rating at the bond insurers these days is worth about as much as the GoodHousekeeping rubber stamp seal of approval on an old blender circa 1952). Also, Buffett has already opened up a new bond insurer that’s going to charge more than his competitors for his Triple A.

And Buffett is only offering to pick off the safest parts of the bond insurers’ business, government bonds that hardly ever default. Investors in bonds issued by the biggest municipality that defaulted, Orange County, Calif., eventually got paid in full (only after the county filed for bankruptcy and only after a protracted court fight).

Muni bonds are considered safe because they are backed by local taxpayers and by hard assets like bridges, tunnels or highways. Which should make you stop and think about why the bond insurers exist at all (yes, yes yes, cheaper yields because of a paper promise that basically reap fat fees for the insurers).

The very idea, as Bill Gross of Pimco points out, that, say, bond insurer Ambac with its microscopic $5bn in capital reserves can insure all of the municipal bonds of California, the sixth largest economy in the world, is absurd.

Again, take a look at the credit risk of munis, the business Buffett likes and wants to make more money off of by reinsuring the bond insurers.

From 1970 to 2005, the 10-year cumulative default rate for all investment-grade municipal bonds was a microscopic 0.06%, compared to 2.23% for comparably rated corporate bonds, says Moody’s.

Moreover, muni bond investors get way more money back after a default than corporate bond investors. The average recovery rate on defaulted municipal bonds has been a fat 66% of par, versus 42% for defaulted corporate bonds.

And muni bond investors have a higher chance of greater recovery. Nearly half of investors in defaulted muni bonds recovered between 75%-to-100% of par, versus 17% for defaulted corporate bonds. Meanwhile, nearly two-thirds of investors in defaulted corporate bonds recovered less than 50% of par.

Moreover, Buffett is not taking on the subprime toxic waste in bond insurers’ portfolios—signs that there is intelligent life in the universe (and I assure you he wouldn’t do it unless he got some government guarantees on that business).

Bond insurers ran headlong into the subprime mess in 1998 when it started collecting fees to insure corporate securitizations like collateralized debt obligations—talk about picking up nickels in front of avalanche boulders, not just steamrollers.

As mortgage defaults rose, bond insurers, such as Ambac and FGIC, have been downgraded by ratings agencies due to their weak capital base. MBIA faces a similar fate.

Buffett wants to leave the smoking wreck of this subprime junk debt crackup behind him on the highway, which makes the bond insurers even more vulnerable to a credit rating downgrade. So is it any wonder Buffett’s phone is not ringing off the hook with calls from the bond insurers?

Nightmare on Wall Street now Nightmare on Elm Street: The problem is spreading. What is likely the greatest credit bubble in the history of the stock market has the Federal Reserve, central bankers around the world, Congress, and banking regulators scrambling.

On top of Fed rate cuts and a $168bn fiscal stimulus plan comes the new plan from six big mortgage lenders, including Bank of America and Washington Mutual, to freeze interest rates and forestall foreclosures on both subprime and prime loans. To date, less than 10% of about 7mn subprime loans have gone through a workout.

And it’s that data that matters—for the market to get back on its feet, investors need to see light at the end of the tunnel and they need to get a grip on the size of the damages. Which is why they’re grabbing onto the Buffett news like a piece of Styrofoam in a tidal wave.

This all calls for a recap.

A recent meeting of the G7, a group of major industrial powers, saw this nail-biter of a report: That write-offs of losses on securities tied to US subprime mortgages could reach $400bn. In addition, Moody’s Investors Service says losses on loans made in 2006 backing residential mortgage backed securities could rise to more than 30%.

This is on top of the $125bn in writedowns on a global basis that financial outfits, including Merrill Lynch, Citigroup, Morgan Stanley and UBS, have already taken. Already, January 30, S&P downgraded, or placed on review, more than 8,000 bonds and CDOs. For its part, S&P says that could double losses in these securities to $265bn. So the range of future losses is $265bn to $400bn.

There’s more. Separate from that, banks are exposed to about $125bn in collateralized debt obligation hedges with bond insurers, says S&P. But just a quarter to a third of those exposures have been disclosed in company filings. Merrill lynch and Citigroup have disclosed their hedges. Merrill Lynch says its hedges have $3.5bn of mark to market value. U.S. financial institutions could face fresh write-downs of as much as $70bn if the bond insurers lose their top rating, with the biggest hits at Merrill Lynch ($7.4bn to $11.8bn), Citigroup ($6.5bn to $10.3bn), and UBS ($5.4bn to $8.7bn), says Meredith Whitney, a top analyst at Oppenheimer.

On top of this, an estimated 150 lenders will fail due to problems at regional and local banks that made loans to developers to build way too many malls, condos, and other properties.

The Fed’s last survey of senior commercial loan officers showed eight out of 10 tightened lending standards on commercial real estate loans, and zero, that’s right, no commercial mortgage backed securities were issued in January—the first time since the survey was taken in 1990.

The regional banks could get wiped out on a large scale. As much as a third of community banks have commercial property loans that would wipe out their capital reserves more than three times over, says the Comptroller of the Currency, John Dugan. RBC Capital Markets figures anywhere from 50 to 150 regionals could go bellyup in by 2010. That’s the highest rate we’ve seen since the S&L crisis of the late 1980s, early ’90s.

All this has got San Francisco Federal Reserve president Janet Yellen coming out saying that while she thinks rate cuts may avert a recession, she remains concerned about the contraction in bank lending (did Yellen get a heads up about the FDIC Quarterly Banking Profile for Q4 2007, set to be released on Feb 21?)

There’s more.

On top of all this, Standard & Poor’s figures that the banks may be stuck with $148bn worth of leveraged buyout loans still in the pipeline waiting to be syndicated. Banks couldn’t syndicate $14bn worth of Harrah’s debt, and puts at risk the $15bn of debt for the buy-out of Clear Channel.

Wall Street’s pain is already on Main Street, with money market funds around the globe suffering losses, even drug maker Bristol Meyers Squibb reporting subprime-related losses. The US Central Federal Credit Union, a big lender to the nation’s coop banks, lost its AAA rating from S&P because of toxic subprime waste in its mortgage portfolio.

Yes the credit markets are thawing a bit but not enough.

The bottom line: The Fed will likely have to cut rates again on March 18 to 2.5%.