When I wrote this post on Berkshire Hathaway, the main point I was going for was that the price of Berky was not unreasonable if one attributed value to what Berky could do in a crisis. When I trotted out the Ambac scenario, the idea was to illustrate how Buffett could if he wanted to, take advantage of a situation where values are depressed because the moats of competitors have been broken. (Think of what he did in manufactured housing finance after all the competitors were nearly destroyed. He bought the one healthy remaining company inexpensively.)
Now, had I been more thorough, I also would have pointed to pieces referencing Buffett and his experience with Gen Re Financial Products. The thing is, Buffett doesn’t like to be an external money manager or lender (for the most part), and
does not like structured finance exposure (even in its infancy, a la Salomon Brothers), he does recognize where there can be a clean, core business with defensible boundaries (a moat), where he can earn above average returns over time — insuring municipal bonds.
One key decision that any businessman must come to when entering a new field is build versus buy. Buy can be more attractive when there might be synergies between the acquirer and the target, or if the purchase price is sufficiently low. Build can be more attractive when the necessity of having something new that is unaffiliated with the old order is more attractive (no legacy liabilities), and where your competitors are viewed as being compromised, whether in balance sheet terms, or ethically. For the latter, think of the revenue lost by major insurance brokers after the Spitzer investigations. New players ate into the business models by avoiding conflicts of interest.
So, the announcement of Berkshire Hathaway Assurance Corp [BHAC] is no surprise here. Warren sees an opportunity, and he will pursue it.
Now here are three weaknesses of doing it this way. Buffett is not going to be the low cost provider, in a business where basis points matter as to who gets the business, and who does not. This strategy implies that he suspects that the major bond insurers have problems more severe than have been discounted by the equity and debt markets, and that their AAA bond ratings will remain under threat for some time. Second, it assumes that the managements of his competitors won’t take some action that significantly dilutes their equity in order to retain the solvency of their franchises, benefitting their own bondholders, those guaranteed by their firms, and management themselves (assuming they aren’t ousted). So far, the infusions to the financial guarantors have been significant, but not significant enough to remove doubt. The purpose of a AAA rating is that it is beyond doubt.
Third, a new startup will have higher fixed costs to amortize over the new business written. Mr. Buffett wants to charge more. Well, he will need to charge more, though perhaps that disadvantage is minimized because his competition faces higher costs in a different way from financial stress:
- Distraction of management over structured finance exposure
- Distraction with the rating agencies
- Distraction over shoring up the capital structure
- A much higher cost of capital than was previously available
- Shareholder lawsuits (coming)
But, if I were in the seat of the competitors, I would tell my municipal divisions to ignore the problems of the company as a whole, and keep writing good business at pricing levels below that of BHAC. That will contribute to the value of the firm, and, the ratings agencies know that the marginal amount of capital needed to write that business against a mature block is almost zero. So keep writing, and protect the franchise.
Finally, it looks like this subsidiary is separately capitalized, and not guaranteed by Berky. It likely gets a AAA on its own, with only implicit support from the holding company. This gives Buffett the option to write a lot of business by providing more capital as needed, preserving flexibility at the holding company, while limiting downside if that subsidiary should ever run into trouble (very unlikely, given their business plan).Tickers mentioned: BRK/A, BRK/B, ABK