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INVESTING: Bond insurers pummeled for straying into risky area

January 14, 2008

As Wall Street continues to record multibillion-dollar losses for its debt-market indiscretions, another industry that for years earned steady returns from the credit markets is sitting on the doorstep of implosion.

For decades, bond insurers operated the relatively mundane business of insuring, and thereby guaranteeing, the timely payment of principal and interest on municipal bonds issued by various government and other entities.

In recent years, the bond insurers strayed from their core business model and underwrote insurance on the new structuredfinance concoctions dreamed up by Wall Street, namely subprime mortgage securitizations and collateralized debt obligations. Now on the hook to cover the insured losses on these various securities, the industry is scrambling to remain solvent.

The four largest insurers are FSA, AMBAC, MBIA and FGIC. MBIA and AMBAC are both publicly traded, and each has seen its stock price decline about 80 percent the past year. FSA is owned by Dexia of Belgium, and FGIC lists the private-equity firm Blackstone Group as one of its owners. The numbers in this business are huge. For example, AMBAC guarantees $556 billion worth of debt, while MBIA insures $652 billion.

At present, these firms are in an all-out blitz to raise capital to protect their AAA rating. A downgrade to below AAA would essentially put these firms out of business, since they would no longer be able to slap the "AAA insured" label on bond issues they guaranteed. The rating agencies-Moody's, Fitch and Standard & Poor's-are in the midst of reviewing their ratings on these companies and essentially hold their fate in the balance.

Even new capital might not be the savior. In recent days, MBIA disclosed in more detail that it insures more than $30 billion in complex mortgage securities. Included in that figure are $8 billion of very risky securities described as "CDOs squared." It almost defies imagination who could dream up such an arcane instrument that was explained as CDOs backed by CDOs. MBIA's exposure to these securities exceeds the company's net worth of $6.5 billion, putting its survival in question. One analyst commented that he was "shocked that management withheld this information for as long as it did."

But of course such dislocations can lead to opportunity for the prepared. And the void in the market has allowed Berkshire Hathaway to step in and start a municipal bond insurance company from scratch, backed by its substantial capital and solid AAA rating. Warren Buffett noted that Berkshire would not "stray off municipal bond insurance. It's too hard to figure out those other things." Buffett also said his bond insurer will charge more than existing insurers on the premise that the strength of Berkshire's guarantee will merit an extra cost.

Last, there is opportunity for the individual investor in municipal bonds. Municipal bonds have turned in their worst total-return performance since 1999. That means there are high-quality, tax-free bonds available at lower-thannormal prices and higher yields due to the market upheaval. One should stick to solid municipal credits whether or not the bonds are insured.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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