Given the unholy mess that is most local government finances, you would think municipal bond insurers are about to be washed away by a tsunami of defaults.
But legendary fund manager Bruce Berkowitz and other savvy investors have bet tens of millions of dollars that this view is wrong.
Companies that insure municipal bonds have been among the best-performing stocks so far this year and that outperformance seems likely to continue.
That's why Berkowitz has made a big bet on muni bond insurer MBIA Inc. (NYSE: MBI).
What's Municipal Bond Insurance?
Municipal bond insurers guarantee the payment of interest and principal to investors if the city, county or state that issued the bond defaults.
Just like any insurance policy, the issuer pays a premium to the insurer for the guarantee. In return, investors are willing to accept a lower interest rate from the issuer because there is no risk of default.
But municipal bond insurance is only as good as the company that wrote it.
Although there are four major municipal bond insurers in the United States, only two, MBIA Inc. and Assured Guaranty Ltd. (NYSE: AGO), trade as stand-alone entities. Warren Buffett's Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B) includes a municipal bond insurer among its portfolio of businesses, but this is a small part of Berkshire's total business.
It is virtually impossible to make any sort of generalizations about municipal bond insurance except that each risk must be examined in detail.
For example, the city of Detroit is scheduled to be taken over by a state-appointed financial manager as of March 27. Investors could not be blamed for thinking that this would likely lead to an increase in defaults on city debt and be bad news for municipal bond insurers.
According to MKM Partners analyst Harry Fong, MBIA has $2.5 billion in exposure to Detroit, of which about $100 million is general-obligation debt, while most of the rest is backed by water and sewer revenues. As for Assured Guaranty, Fong says it has about $2.8 billion in exposure to Detroit, of which $355 million is general-obligation debt, $1.85 billion is backed by water and sewer revenues and $600 million is exposed to the Detroit school district.
"Water and sewer revenue bonds would almost certainly be unaffected in the event of a bankruptcy, as the city cannot divert revenues from the utilities for general purposes," Fong writes. Fong says that the new financial manager "will have the power to sell municipal assets, restructure services, restructure labor contracts and reorder the city's finances."
So the municipal bond insurers' actual exposure to bankruptcy risk in Detroit is much smaller than their total exposure to the city.
If Detroit were to declare bankruptcy, it would not be good news for the insurers but it would not be a disaster, either.
Would You Invest with Bruce Berkowitz?
Bruce Berkowitz is the manager of Fairholme Funds, MBIA's largest shareholder and the largest holder of MBIA debt.
Berkowitz argues that MBIA is grossly undervalued. He sees three catalysts for realizing the value in MBIA:
1. MBIA has two businesses, National Public Finance Guarantee Corp., a municipal bond insurer which is very profitable and, as a standalone business, is worth about double MBIA's current share price, and MBIA Insurance, which insured residential mortgage-backed security.
2. The company has been aggressively reducing its exposure to structured financial products, greatly reducing risk.
3. MBIA is in the final stages of a lawsuit against the Countrywide unit of Bank of America (NYSE: BAC ), claiming that Countrywide fraudulently misrepresented the quality of the second mortgages it underwrote, which were later securitized and insured by MBIA. MBIA has paid more than $6.5 billion in claims on these RMBS.
If the company wins the lawsuit, it could get anywhere from $3 billion to $6 billion back from BAC. A lower court found in favor of MBIA last week. BAC is appealing to a higher court now.
If MBIA loses the case, Berkowitz feels that the losses are already discounted in the MBIA share price. If MBIA wins, the entire company would return to a solid financial footing and be able to grow its business again.
And a pullback in shares of either MBIA or Assured Guaranty on a bankruptcy in Detroit or elsewhere could be a great opportunity to jump in and join Berkowitz, Warburg Pincus and other clever investors in riding the municipal bond insurers back toward more normal valuations.
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The Washington Post:
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The Wall Street Journal:
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