Buffett offers $800bn bond lifeline

Warren Buffett, the billionaire investor fêted as the "Oracle of Omaha", has emerged as a key player in negotiations to restore order to the municipal bond market in the US, a vital source of funds for US local government and a key plank of the financial system that has been threatened by the credit crisis.

In letters to several of the ailing "monoline" insurance companies, whose guarantees back hundreds of billions of dollars of municipal bonds, Mr Buffett proposed taking over some $800bn (£410bn) of their bond insurance business.

His proposal came after talks with the monoline insurance industry's main regulator, Eric Dinallo, insurance superintendant for the state of New York, who has been trying to assemble a rescue deal for the leading companies including MBIA, FGIC and Ambac.

The future of MBIA and Ambac has been thrown into doubt because they face mushrooming losses in another part of their business, insurance for the complex derivatives linked to mortgages, whose value has collapsed and where defaults are rising.

Mr Dinallo fears that the collapse of a monoline insurer, or even a downgrade to their credit ratings, could have ripple effects across the financial system. Already, Mr Buffett said, municipal bonds are changing hands at a steep discount, as if investors did not have full insurance against a default. That threatens to raise the cost to local government of issuing more bonds in the future, adding to the financial difficulties municipalities may face if an economic downturn cuts tax receipts.

If muni-bond insurance became valueless, many risk-averse investors may be forced to sell the bonds, exacerbating the problem.

Mr Buffett told CNBC television that his plan would "solve it in one stroke of a pen". His company, Berkshire Hathaway, would reinsure $800bn of municipal bonds, putting its gold-plated triple-A credit rating behind the bonds and restoring confidence. "At the moment, the insurance in the market is not doing bondholders any good and is in some cases penalising bond investors," he said. "Our proposal puts the municipals at the front of the line."

So far, Mr Buffett's letters have solicited a response from just one of the three main monoline insurers – he would not say which one – and the response has been negative. Analysts said that this was hardly a surprise given that it would mean ceding the solid part of the company's business to Berkshire Hathaway, while leaving the mortgage derivatives business where all the problems are located. Such a downsizing might free up capital, but it would be fraught with risks. On hearing of the Buffett plan, financial markets yesterday priced a higher risk of MBIA and Ambac defaulting on their own corporate bonds.

Cynthia Cole, a fund manager at Allegiant Asset Management in Cleveland, said Mr Buffett would be profiting handsomely, since he would be charging more for the reinsurance than the premiums that the monolines are actually receiving. "The cost is extremely high for the bond insurers," she said.

None the less, analysts predicted that the monolines might ultimately be forced to cede their muni-bond business in order to ring-fence it from their other troubles and forestall a serious new problem in the credit markets.

Equity markets rallied and safe-haven US Treasuries fell thanks to a wave of optimism unleashed by Mr Buffett's intervention, and Mr Dinallo responded positively to the Berkshire Hathaway proposal. "I am pleased this provides one more option to protect muni-bond issuers and investors," he said.

Monoline insurers have gradually moved to the centre of the stage as the credit crisis has unfolded. On the one hand, local politicians and administrators have become concerned about the threats to the muni-bond market, while on the other, many big Wall Street banks have relied on their guarantees cov-ering mortgage-related and other complex derivatives. A credit-rating downgrade of one small monoline insurer last month forced Merrill Lynch to write off $2.6bn, and much bigger sums could be wiped out if a leading monoline is downgraded.