5 Reasons Why Buffett Can't Rescue the Bond Market

The "Oracle of Omaha" has a plan to bail out the bond insurers—for a profitable price.

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Finally some good news for the bond market. Warren Buffett offered today to take $800 billion of liabilities off the hands of leading bond insurers—MBIA, Ambac, and FGIC Corp.—who are facing billions of dollars in losses and potential ratings downgrades. The news sent a jolt of optimism through Wall Street—pushing the Dow up more than 200 points at one point—as investors hoped the lifeline could get bond insurers out of their jam and restore stability to the credit markets

But here's why that's unlikely to happen:

1) Buffett wants only the munis: Although struggling bond insurers are in desperate need of assistance, don't expect them to tear up at Buffett's plan. After all, the Oracle of Omaha would assume responsibility for only the insurers' municipal businesses, leaving the companies to deal with their rapidly devaluing mortgage debt portfolios for themselves. But potentially devastating problems have come from the mortgage side—not municipal debt—and leaving their most profitable business at a time when they need cash the most doesn't make much sense.

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, expects the bond insurers to reject the offer, since it is essentially "skimming the cream off the top" of their business. "The monolines themselves have this huge cash cow business, which is insuring [municipal bonds], and to some extent you could argue that that's relatively easy money," Backshall says. Without it, the companies would have "nothing but sort of toxic waste left behind."

Not surprisingly, one of the companies has already rejected the plan, and the other two have not yet responded.

2) It won't head off potential ratings downgrades: While the plan would allow the companies to free up some capital, agreeing to the plan could actually make a bond insurer more likely to have its credit rating downgraded by one of the key agencies. Should a bond insurer agree to the plan, it would "lose [its AAA rating] almost definitely because the only real viable business that you have you are conceding to a competitor," says CreditSights analyst Rob Haines.

3) Capital concerns remain: Even if the companies were to accept Buffett's plan, it would have little affect on their capital needs. While a smaller municipal portfolio would allow bond insurers to hold less cash, their real capital requirements come from the mortgage side, which Buffett doesn't want.

4) Credit markets see increased risk. While the stock market welcomed the move, credit markets responded negatively. Credit default swap spreads on bond insurer debt widened in the hours after the plan was announced, indicating that investors perceive the plan as having made bond insurers more—not less--risky, Backshall explains. It makes perfect sense; Buffett's plan would reduce bond insurers' income stream from safe, stable municipal bonds, thereby increasing their net exposure to more risky, mortgage debt.

The credit default swap spread on MBIA's AAA-rated bonds, for example, widened 45 basis points in the early part of the day, Backshall says. "Investors are seeing them as more likely to default now than at 6 o'clock this morning," he notes.

5) Credit markets: Problems new and old persist. The news of Buffett's plan comes as a slew of indicators show that the credit markets are deteriorating further under the weight of problems—some old, some new. Banks are having difficulty unloading loans that were used to finance corporate buyouts. Commercial real estate loans are becoming less available, with 80 percent of domestic banks reporting that they have tightened standards for such loans in the past three months. And recently, Comptroller of the Currency John Dugan predicted "there will be an increase of bank failures."

While financial institutions have already taken billions of dollars in mortgage-related writedowns, more are sure to come. German Finance Minister Peer Steinbrueck recently said that the U.S. subprime debacle could cost financial institutions around the world some $400 billion of writeoffs. And there's nothing that Buffett or the beleaguered bond insurers can do about that.