Monday, January 7, 2008

Warren Buffett's New Bond Insurer: a Commentary on Financial Reporting

The recent announcement that Berkshire Hathaway, the public company headed by Warren Buffett, is establishing a bond insurer is, unintentionally, one of the sternest criticisms yet of the financial reporting and disclosures by the firms involved in the mortgage crisis and associated problems.

Buffett is best known for his skill at identifying promising established businesses. He invests in them, leaves management in place to do its job, and counts up the money as it rolls in. What he hasn’t done much of is rent space in a sagging strip mall, put fliers on parked cars, advertise on the local UHF stations, sponsor the greased pig contest at the county fair, and do all the other things that business startups have to do.

But now, he has a newly minted license from New York State to insure bonds. The business strategy is obvious. The major bond insurers, like Ambac, MBIA and others, have incurred painful losses from their poorly timed entry into the business of guaranteeing mortgage-backed obligations. These insurers, whose credit ratings are imperiled, would not exactly be the first choice today of municipalities seeking to beef up the creditworthiness of their bonds. A fresh face in the industry, with a pristine balance sheet and a glamorous name (for the financial world) like Warren Buffett attached to it, will probably attract customers from far and wide.

That Buffett would start his own bond insurance operation reflects poorly on the financial reporting and disclosures of the firms involved in the subprime mess. Their losses seemingly came out of nowhere. How many investors can say they were aware of the potential for such losses? What disclosure was made? And if it was made, was it buried in footnotes or boilerplate listings of possible risks? Were financial statements misleading because they did not include affiliated structured finance vehicles like SIVs and conduits? The established bond insurers apparently didn't see this train wreck coming. And they're in the business of identifying and evaluating risks like these.

The established bond insurers are obvious candidates for takeovers, given that their weakened financial condition leaves them with few options. The unusual emergence of Warren Buffett as entrepreneur suggests that he couldn’t follow his usual strategy of buying an established business because he couldn’t figure out how much risk it entailed and what it would be worth. His decision to start a new business takes exquisite advantage of the question marks over the financial statements of the established bond insurers and the opacity of the financial reporting and disclosures by firms involved in mortgage-backed investments. Whether or not they complied with the rules, the uncertainty surrounding their financial condition is enough to provide an opening for a new kid on the block.

Animal News: don't saddle up and ride a buffalo. Did you know that already?

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