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Somehow I missed this but that doesn’t mean anything, I miss a lot of things. So if you’re up to speed on the government providing reinsurance for municipal bonds then skip this post.

If not, here is a little blurb I found on Fox Business:

Congressional Democrats are working on measures to offer government insurance for municipal bonds and may introduce a bill as early as next week, people familiar with the situation tell FOX Business.

This move comes as local governments are trying to convince investors to finance public debt.

One of the people familiar with the matter says the House Financial Services Committee will move a bill for the federal government to offer reinsurance for municipal bond insurance. The source says lawmakers have also been pushing for the Federal Reserve to do so.

I like that part about getting the Fed into the insurance business, don’t you. Anyway, this jogged some dormant synapses but they fired blanks until a little while ago. Then I remembered that Buffett had some choice words for municipal bond insurance in his annual shareholders’ letter, so I dug that up.

Berkshire (NYSE:BRK.A) started dipping its toe in the municipal bond insurance business early in 2008. It wrote a lot of second to pay insurance early in the year and did about $3.7 billion of primary business in 2008. The trials and tribulations of the monolines has made it the preferred municipal bond insurer. Despite a good start for the business, Buffett contends that Berkshire is extremely cautious about the business and even goes so far as to say he does not know if it will ultimately prove to be a good business.

Here (Starts On Page 13) is his analysis (Sorry, it’s a little long but you need to see the logic):

The rationale behind very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely reflects the experience of entities that issued uninsured bonds.

Insurance of tax-exempt bonds didn’t exist before 1971, and even after that most bonds remained uninsured.

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different.

To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belt tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Local governments are going to face far tougher fiscal problems in the future than they have to date. The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at year end 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering. When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents.

Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?

Insuring tax-exempts, therefore, has the look today of a dangerous business – one with similarities, in fact, to the insuring of natural catastrophes. In both cases, a string of loss-free years can be followed by a devastating experience that more than wipes out all earlier profits. We will try, therefore, to proceed carefully in this business, eschewing many classes of bonds that other monolines regularly embrace.

I think that’s fairly clear. There is a dearth of real underwriting experience from which to draw and the tenuous state of municipal finances demands strict underwriting. Pretty obvious. Now do you think that’s the way the federal government will approach the business.

If you do I have several bridges I have been holding in portfolio that you can have at quite a reasonable price. The spin for getting into this business is going to be that it is difficult for municipalities to obtain insurance for their bonds at this time and the government needs to step in and fill the void. Nowhere in all of the gas that will emanate from Capitol Hill will you hear anything about why no one wants to insure these bonds.

The business model is already in place. It’s called the flood insurance. As I’m sure you know, the federal government insures homes and businesses against flood damage in areas in which private insurance companies choose not to write. You know, coastlines that are routinely savaged by hurricanes. Just to make sure they have lots of business, they underprice this insurance to encourage people to build in the risk prone areas so they can pay off claims routinely and collect more premiums when they rebuild. It’s a gigantic money loser but they have lots of clients.

Naturally this same nose for the insurance business will be applied to municipal bond insurance. It’s a bad idea at a bad time but that doesn’t mean that it won’t come to pass. I’ve a couple other thoughts on this which I’ll try and cover in a post tomorrow.

Source: Why the Government Doesn't Belong in the Municipal Bond Business