Monday, February 04, 2008

Watching the falling knife go by

The bond insurance business model is split into two parts. The first is the simple and traditional activity that Berkshire Hathaway is stepping into; insuring and upgrading the credit of municipal bonds for a fee with the promise of making bond holders whole if the issuing agency defaults. The second is a world of magic, voodoo and potential half trillion dollar losses. This is the part of the business model that everyone with money and brains is now trying to avoid, including major private equity firms that don't think the risk is worth a bail-out.

Leading private equity firms are unlikely to participate in any recapitalisation of Ambac and MBIA, increasing the pressure on banks to come up with a rescue package for the troubled US bond insurers....These investors have all concluded that the risks are too great, according to people familiar with their thinking....

The reluctance of big private equity firms to become involved comes after they looked closely at the two large monolines. They also studied the experience of Warburg Pincus, which committed $1bn to MBIA in early December at what seemed an attractive price, only to see MBIA's share go into freefall. Additionally, they noted that Blackstone, which has a minority stake in FGIC, had so far declined to put more money into that troubled bond insurer.

"If we worry that we can get shot from the shadows by something we can't see coming, it is not for us," says the managing director in charge of financial service investments for one of the leading private equity funds.

"The financial guarantors pass neither the shadow test nor the ability-to-understand test."[emphasis mine]

Risk is real, and it can be costly, but it can be calculated and hedged against by either a very cheap purchase price, or writing a complex set of options. Uncertainty is unmeasurable and that is what is killing the potential of a smart deal here. However uncertainty is pervasive right now because no one knows what else is coming out of the fiasco and no one can trust the word of the monoline insurers.

If private equity steps into the bond insurance market it will be to salvage the institutional expertise of a failed insurer and focus exclusively on the highly profitable but boring business of municipal bond insurance.

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