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FT REPORT - FUND MANAGEMENT: The world of municipals and Mr Buffett
By Gary Vaughan-Smith
Published: Feb 04, 2008

Berkshire Hathaway's recent entry into the obscure world of municipal bond insurance raises an interesting question: what has attracted Warren Buffett to this business area?

To answer this, one needs to understand the perverse way rating agencies systematically
under-rate municipals. Their bizarre approach has resulted in municipals, for which read
taxpayers, paying up billions of dollars each year for insurance they do not need. And this has been going on for more than three decades.

The important point to understand is that a credit rating will mean something different for
different types of borrowers. When a rating agency rates a municipal single-A, that does not
imply the same default risk as a corporate or collateralised debt obligation that is also rated
single-A.

To take an example, a study by Standard & Poor's showed the 10-year cumulative default rate on single-A rated municipals was 0.04 per cent; on corporates it was 1.8 per cent; and on CDOs it was 2.7 per cent. In fact, this low default rate for single-A rated municipals was even better than that of corporate triple-A rated bonds, which recorded a rate of 0.44 per cent.

Additionally, when municipal bonds default the expected recovery rate is 90 per cent compared with 50 per cent on corporate bonds. Moody's, in a recent study, said if states were evaluated in the same way as corporates, 49 of them would be rated triple-A.

How about municipal bonds rated non-investment grade or "speculative" by the rating agencies (that's "junk" to you or I)? Taking BB bonds as an example, the Standard & Poor's study showed the cumulative default rate for these bonds was 1.35 per cent, better than those "investment grade" single-A rated corporate bonds. Looking at it another way, the cumulative default rate for corporate BB bonds was about 18 per cent, nearly 13 times higher than the municipals with the same rating.

Confused? So are we.

The rating agencies long ago abandoned the principle of rating a bond by its risk irrespective of who the issuer is. It is unclear why rating agencies have systematically under-rated municipals but one fact is clear: municipals do not pay as much as corporates to get a rating. And corporates, in turn, do not pay as much as CDOs. The more you pay, it seems, the better your credit rating.

Of course, once the municipals have been given the discounted rating, the next step is to
persuade them to buy insurance to lift their rating to triple-A.

Step forward the monoline credit insurers. And why not? Selling insurance to people who do not need it has to be a great business. Here's the pitch: "You're a municipal that should be rated triple-A but the rating agencies have given you a single-A rating. Don't worry, pay us an insurance premium and we will insure your bond to be triple-A. Our balance sheet? We have
net assets less than 1 per cent of the amount that we have already insured. But don't worry,
hopefully our other clients didn't need the insurance either."

And it is a decent-size insurance segment as well. About half the $2,500bn (£1,257bn,
€1,684bn) municipal bond market is insured and the insurance premiums are, conservatively, in the $2bn-$3bn per annum range. That's $2bn-$3bn of taxpayer money.

For some municipals, credit insurance makes sense. It may help them in their fund-raising and may work out cheaper overall than issuing the bond without the insurance. On the other hand, it is hard to escape the feeling that municipals, hospitals and schools are overpaying for this insurance because of they are rated.

The rating agencies are under some scrutiny for their role in the subprime mess. We would expect their treatment of municipals to also come under the harsh glare of public scrutiny. We would also guess Berkshire Hathaway's business plan growth assumptions will be difficult to meet as municipals wise up to this waste of taxpayers' money.

Gary Vaughan-Smith is chief executive of SilverStreet Capital
Copyright The Financial Times Limited 2008