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in premiums (up from $4.5 billion at the end of 2007) for puts it wrote on equity indexes, and the first payment—in the unlikely event one ever comes due—is 2019. Berkshire Hathaway took a mark-to-market loss it can afford, a write-down of $1.7 billion in the first quarter of 2008. Magen Marcus, a medical doctor who has been a Berkshire Hathaway shareholder for five years, called them “unrealized losses.”55 He is an informed shareholder. In his 2007 shareholder letter, Warren told us that he and Charlie Munger are not concerned about the price fluctuations: “even though they could easily amount to $1 billion or more in a quarter—and we hope you won’t be either.”56 They are willing to cope with reported earnings volatility “in the short run for greater gains in net worth in the long run.”57

Berkshire Hathaway does not chase revenues for the sake of revenues; the price must be right. When rating agencies suggested that Berkshire Hathaway should increase insurance revenues to maintain its AAA rating, Warren told me he rejected their premise. Berkshire Hathaway is happy to do nothing when the risk is not priced correctly, but many insurance companies did not feel the same way. This critical difference led to an opportunity for Warren Buffett he never sought. An insurance regulator knocked on Berkshire Hathaway’s door when it needed help.

Chapter 11

Bond Insurance Burns Main Street

You have been writing some terrific stuff. I send it along to Ajit and he’s now a big fan.

—Warren Buffett

to Janet Tavakoli, January 3, 2008

When he was in his twenties,Warren Buffett put three-quarters of his money (around $10,000) into property and casualty insurer GEICO, and reaped a healthy profit. Since then, he has been keenly interested in insurance opportunities. The credit crisis dropped an opportunity in Berkshire Hathaway’s lap.

As Bear Stearns and the Carlyle fund struggled for their survival on March 12, 2008, news about bond insurance was not a highlight, but it should have been. In what would become an ugly pattern, one of the bond insurers that had been AAA at the start of 2008 was downgraded several grades (by Fitch), and it filed a lawsuit in an attempt to nullify a nearly $2 billion guaranty.1

Bond insurers traditionally provided credit enhancement for municipal bonds needed to fund roads, schools, water treatment plants, and many other necessary public works. Now bond insurers are an integral part of the credit bubble problem. Most of the bond insurers (or monolines2) have exposure to subprime home equity loans or troubled loans bundled in risky securitizations. Most bond insurers have done dicey deals dirt cheap. Most of them need more money. It is as if they offered hurricane insurance on homes and insured everyone in Florida without enough money to cover potential obligations. Instead of insuring homes, the insurers were insuring bonds without enough money to cover the potential obligations or to keep their AAA ratings. Their folly affects the average American taxpayer and many retail accounts.

Bond insurers provide guarantees for municipal bonds, which often have very long maturities. The interest rate is set at periodic auctions, and these auction-rate securities (ARS) were sold as if they have been like a cash instrument or a money market instrument.The same day in March 2007 when the bond insurer filed its lawsuit, I was in New York. I met with the CEO of a large foreign manufacturing company. He told me he was suing the investment bank that sold his cash manager more than $10 million in auction-rate municipal bonds guaranteed by a bond insurer. “[The investment bank] told him it is the same as cash.” By February 2008, around 70 percent of the $330 billion auction-rate securities market for municipalities, student loans, and colleges failed when investment banks and banks stopped bidding for the “insured” bonds that investors wanted to sell (or did not want to buy).

Usually auction-rate bonds are bought and sold at a prespecified short period such as every 7 or 28 days.The interest rate is