Warren Buffett-Municipal Bonds-Bond Insurers

I love watching The Oracle of Omaha, Warren Buffett.  Yesterday, he caused the Dow Jones Industrial Average to move up over 130 points by making a simple announcement.  What did he say?  He offered to “help”, and I use that term lightly, troubled re-insurance companies Ambac (ABK), MBIA (MBI), and Financial Guaranty.

Whenever these offers arise, you have to analyze who they really help.

His offer really doesn’t benefit these companies much . . . and in my opinion may actually hurt them.  But, it did give me a great investment idea (more on that in a minute).

Here’s why this is a bad deal for these guys.

Ambac, MBIA, and Financial Guaranty are all big re-insurance companies.  They’re a little different from your homeowners or car insurance company in that they don’t insure people or property, they insure financial securities.  Here’s how it works.

Let’s say you work for the city and have been put in charge of building a water treatment facility.  The population is growing and everyone needs clean water.  You design the plant and get quotes from construction companies.  Before getting started you need to raise money for the project.

To do that you need to sell bonds.

To sell bonds, you meet with a number of investors.  These pension funds, insurance companies, and endowments all have billions of dollars to invest, and they like your project.  Best of all, your bonds are backed by the local government as they’re municipal bonds.  This provides a level of safety and gives tax advantaged status to certain holders.

But you have a small problem.  The interest rate investors want is higher than you anticipated.  You call one of the big re-insurance companies and find out that you can purchase insurance on your bonds.  Essentially, the re-insurance companies promise to make good on the bonds if your project fails.  This gives investors more comfort and allows you to get a lower interest rate.

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