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Berkshire Hathaway (BRK.B)
Berkshire and Bond Insurance - Good Idea?
This is the week when most Americans traditionally take it easy. The financial markets are no different. The volume on most exchanges is light as traders recover from the Christmas holiday and prepare for the New Year. But Warren Buffett frequently likes to go against the grain and do things differently. Hence, Berkshire Hathaway just had one of its busiest weeks of the year. On Christmas day, the company announced that it will layout $4.5 billion to purchase a 60% stake in the manufacturing and services concern Marmon Holdings (a company that has interests in 125 different businesses, one more staid than the other, just like Mr. Buffett likes it) and today Berkshire purchased a reinsurance unit from ING (ING: Charts, News, Offers) for $443 million. But that event is overshadowed by the fact that Warren Buffett disclosed that Berkshire is entering a brand new business today - that of bond reinsurance. So what's the rationale behind getting into a business which has been in the news for all the wrong reasons recently and how is Berkshire's stock looking heading into 2008?
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The move to get into the bond insurance business might be a little surprising but it's not something that was completely unexpected. The business itself is quite lucrative - that is if you can stay disciplined. Bond insurers guarantee bond holders that the issuer of the bond will meet all its obligations towards them (e.g. not default on interest payments). Bond issuers pay a fee to a bond insurer in order to make sure that their bonds take on the credit rating of the insurer (typically triple-A) which in turn means that they have to pay out a lower interest rate to bond holders. Since, in most cases, the issuers do not default, the insurer just pockets the premium. If you are a bond insurer, the part about keeping your discipline comes in when instead of insuring every type of bond under the face of the earth, you selectively study the risks associated with each set of bonds and insure only those where the risk of default is low or at least commensurate with the premium you are pocketing. But the two big players in the bond insurance field, MBIA (MBI: Charts, News, Offers) and Ambac (ABK: Charts, News, Offers) haven't done a great job of that as they wrote policies for a number of CDOs (collateralized debt obligations) and as has been well documented, the turmoil in the mortgage market has caused the value of these instruments to fall. Therefore, investors believe that a number of these bonds will default over the coming months and companies such as MBIA and Ambac, who insured these bonds, will have to step up and cover the losses. This could hurt their capital base which in turn will hurt their credit rating (which need to be a pristine triple-A for these firms to do business). That is why MBIA's stock has lost about 70% of its value over the last 3-4 months and the company recently admitted that it has insured about $8.1 billion of the riskiest mortgage securities. It had been, at best, ambiguous about this exposure in the past. However, MBIA and Ambac, both, still retain their triple-A rating though their ratings have been put on negative watch at Fitch and Standard & Poors.
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It is under this environment that a lot of people felt that Berkshire Hathaway had to eventually step in. Mr. Buffett is known for having a penchant for distressed assets and he usually steps in to buy things when everything is dire and most people are selling. Therefore, the smart money was on Berkshire stepping in with a large capital infusion in MBIA or Ambac. But instead, Mr. Buffett, armed with $45 billion in free cash on his balance sheet and a triple-A credit rating, is striking out on his own and will start his own bond insurance business, namely Berkshire Hathaway Assurance Corp. This entity has already been approved for a license in New York and will start operations within the next couple of days. It will focus on insuring low-risk bonds such as those issued by municipalities and states to finance public projects and will stay away from the bonds of the more exotic (and dangerous) variety such as those backed by credit card or mortgage debt. But despite the fact that Mr. Buffett has a track record which speaks for itself, there is no guarantee that this new bond insurance venture will be a slam dunk. The big challenge will be persuading municipalities that they should pay the high premiums that Berkshire will charge because a lot of them might just reach the conclusion that paying a higher interest rate is cheaper than buying bond insurance from Berkshire. Also, even though MBIA and Ambac have been basically left for the dead, there is a good chance that Wall Street is overreacting and the defaults that these two companies are expected to face will not be that high after all. And if that is the case, then MBIA and Ambac will be viable competitors to Berkshire offering cheaper premiums.
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As far as the overall Berkshire Hathaway holding company is concerned, its stock has done extremely well this year as investors have sought refuge in it while the Wall Street banks have seen their stocks hammered. Berkshire's stock (both class A and class B which is 1/30th the value of class A) is up over 28% this year. It might be due for a pull back next year because valuations are getting expensive. As Barron's recently pointed out, the company is now valued at 20 times earnings while a number of stocks in the insurance industry trade at around 10.
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