Buffett offer spotlights financial sector woes
Berkshire wasn't interested in the more exotic aspects of the bond insurers' business, which is more evidence that bankers and insurers still face tough times ahead.
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NEW YORK (Fortune) -- Investors hoping to find a bottom in the hard-hit financial sector can't have been reassured by Warren Buffett's actions this week. Buffett's Berkshire Hathaway said Tuesday it is willing to effectively take over the muni bond books of MBIA and Ambac, a pair of insurers whose shares have been hammered over the past year on worries about their exposure to depreciating mortgage-backed securities.
Ajit Jain, head of Berkshire's reinsurance unit and right hand man to Buffett, told MBIA's bankers at Lazard in a letter last week that Berkshire (BRKA, Fortune 500) was interested in effectively taking over the firms' municipal bond business. Buffett is naturally drawn to the muni business by its solid profitability and the low risk of defaults by municipal bond issuers - and, as is his practice, he proposed a price that would ensure Berkshire shareholders will make out if a deal takes place.
But as much as Buffett likes the municipal bond insurance business - so far, no one seems to have taken up his offer - he appears equally repelled by the inscrutability of the rest of MBIA and Ambac's operations - such as insuring riskier securities including collateralized debt obligations, or CDOs. Jain spelled out that fact in no uncertain terms in his Feb. 6 letter to Lazard deputy chairman Gary Parr. "Unfortunately, the structured finance 'side' of the business, with its many moving pieces and interdependent variables, has proved to be beyond our ability to adequately analyze," Jain wrote.
Jain made the comment about MBIA, but the events of recent months show that it could just as easily apply to any number of financial sector titans. On Monday, AIG (AIG, Fortune 500) shares posted their biggest single-day drop in two decades after the insurer admitted that it had misstated the size of possible writedowns tied to its exposure to asset-backed CDOs. Last year, Merrill Lynch (MER, Fortune 500) and Citi (C, Fortune 500) changed their chief executives after the firms had to substantially increase multibillion-dollar estimates of their CDO-related losses. The suspicion that we haven't seen the last of the securities-valuation problems continues to weigh on financial stocks. Citi has lost more than half its value over the past year, and Merrill is down 45% from last year's highs. Ambac (ABK) and MBIA (MBI) are down 90% and 85% from their early 2007 peaks.
David Merkel, chief economist and director of research at broker-dealer Finacorp Securities, says the problem is that investors "can't get enough clarity" on how big or long-lived the problems might be. MBIA, for instance, has been under attack from short-sellers led by Pershing Square Capital manager Bill Ackman, who has questioned the company's accounting and says it could be insolvent by year-end.
That notion is disputed by investors who say the bond insurers' potential exposure to losses has been overstated by critics who benefit from the stock's decline. The bond insurers' supporters say there is no certainty that Ambac and MBIA will pile up the billion-dollar losses that Ackman estimates. They also note that the bond insurers generally have the advantage of paying out claims as they are incurred, rather than upfront in one huge dose. While both firms took multibillion-dollar mark-to-market writedowns of their credit portfolios in the latest quarter, for instance, the actual claims they paid out were just a fraction of that figure.
Be that as it may, that argument doesn't necessarily constitute a good reason for owning these stocks. Merkel sees the prospect of "a lot of downside" for shareholders in MBIA and Ambac as the companies face possible losses and the need to rebuild their capital bases. MBIA has already raised some $2 billion this year, from investors including private equity firm Warburg Pincus. Merkel adds that he believes it's entirely possible that MBIA and Ambac will still be standing five years from now.
But what's unknowable is "how deep is the valley" the companies will have to traverse between now and then - which is one reason an investor like Buffett, with his credentials as a savvy value buyer, is pitching reinsurance deals rather than wholesale takeovers. With debt markets stressed and asset prices under pressure, Merkel says, "conservatism is highly warranted." 
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