From the Detroit Free Press
Kevyn Orr speaks after meeting with creditors: Kevyn Orr speaks to the media after meeting with creditors at the Westin Hotel at Detroit Metropolitan Airport. Mandi Wright/Detroit Free Press
Detroit emergency manager Kevyn Orr laid out an extraordinary, complex and painful path back to solvency for the City of Detroit Friday in a proposed plan to creditors that promises at the same time a way out of the financial mess that has crippled public services and a path for future growth.I don't know if monoline insurers Assured Guaranteed, Ambac and MBIA are on the hook for any of Detroit's debt but they are the ones to watch. Additionally Berkshire jumped back into the muni bond insurance biz this spring after having famously exited it. We know that Berkshire has no Detroit exposure.
Orr’s plan would spin off the city’s water department, reduce city-provided health care for retirees and current workers and immediately stop debt payments. The money for those payments would instead be used to keep the city operating while reinvesting $1.25 billion over the next decade to boost crucial services like police and fire, step up blight removal and transform the operations of an antiquated, failing city government.
The impact of the document Orr released publicly and to creditors in a historic meeting this morning cannot be overstated.
Orr and his team discussed a staggering amount of liabilities — as much as $20 billion — Friday as they met with as many as 150 creditors called together in a bid to win an out-of-court settlement of the city’s financial collapse or, at least, a municipal bankruptcy proceeding in which most creditors would agree to deals before a Chapter 9 petition is filed.
■ PDF: Read Kevyn Orr’s full report to Detroit creditors
“Detroit’s road to recovery begins today,” Orr said. “Financial mismanagement, a shrinking population, a dwindling tax base and other factors over the last 45 years have brought Detroit to the brink of financial and operational ruin. We cannot repeat the mistakes of the past — the city, its region and the country deserve better....MORE
Buffett's 2008 Letter to the Shareholders of Berkshire Hathaway is instructive:
Tax-Exempt Bond Insurance
Early in 2008, we activated Berkshire Hathaway Assurance Company (“BHAC”) as an insurer of the tax-exempt
bonds issued by states, cities and other local entities. BHAC insures
these securities for issuers both at the time their bonds are sold to the
public (primary transactions) and later, when the bonds are already
owned by investors (secondary transactions).
By yearend 2007, the half dozen or so companies that had been the major players in this business had all fallen into big trouble. The cause of their problems was captured long ago by Mae West:
“I was Snow White, but I drifted.”
“I was Snow White, but I drifted.”
The monolines (as the bond insurers are called) initially insured only tax-exempt bonds that were low-risk.
But over the years competition for this business intensified, and rates
fell. Faced with the prospect of stagnating or declining earnings, the
monoline managers turned to ever-riskier propositions. Some of these involved the insuring of residential mortgage obligations. When housing prices plummeted, the monoline industry quickly became a basket case.
Early in the year, Berkshire offered to assume all of the insurance issued on tax-exempts that was on the
books of the three largest monolines. These companies were all in
life-threatening trouble (though they said otherwise.) We would have
charged a 1% rate to take over the guarantees on about $822 billion of
bonds.
If our offer had been accepted, we would have been required to pay any losses suffered by investors who owned these bonds – a guarantee stretching for 40 years in some cases. Ours was not a frivolous proposal: For reasons we will come to later, it involved substantial risk for Berkshire.
If our offer had been accepted, we would have been required to pay any losses suffered by investors who owned these bonds – a guarantee stretching for 40 years in some cases. Ours was not a frivolous proposal: For reasons we will come to later, it involved substantial risk for Berkshire.
The monolines summarily rejected our offer, in some cases appending an insult or two. In the end, though, the turndowns proved to be very good news for us, because it became apparent that I had severely underpriced our offer.
Thereafter, we wrote about $15.6 billion of insurance in the secondary market. And here’s the punch
line:
About 77% of this business was on bonds that were already insured,
largely by the three aforementioned monolines. In these agreements, we
have to pay for defaults only if the original insurer is financially
unable to do so.
We wrote this “second-to-pay” insurance for rates averaging 3.3%. That’s right; we have been paid far more
for becoming the second to pay than the 1.5% we would have earlier
charged to be the first to pay.
In one extreme case, we actually agreed
to be fourth to pay, nonetheless receiving about three times the 1%
premium charged by the monoline that remains first to pay. In other
words, three other monolines have to first go broke before we need to
write a check.
Two of the three monolines to which we made our initial bulk offer later raised substantial capital. This,
of course, directly helps us , since it makes it less likely that we
will have to pay, at least in the near term, any claims on our
second-to-pay insurance because these two monolines fail. In addition to
our book of secondary business, we have also written $3.7 billion of
primary business for a premium of $96 million. In primary business, of course, we are first to pay if the issuer gets in trouble.
We have a great many more multiples of capital behind the insurance we write than does any other monoline. Consequently, our guarantee is far more valuable than theirs. This explains why many sophisticated investors have bought second-to-pay insurance from us even though they were already insured by another monoline. BHAC has become not only the insurer of preference, but in many cases the sole insurer acceptable to bondholders.
Nevertheless, we remain very cautious about the business we write and regard it as far from a sure thing
that this insurance will ultimately be profitable for us. The reason is
simple, though I have never seen even a passing reference to it by any
financial analyst, rating agency or monoline CEO.
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.
************
The type of fallacy involved in projecting loss experience from a universe of non-insured bonds onto a deceptively-similar universe in which many bonds are insured pops up in other areas of finance. “Back-tested” models of many kinds are susceptible to this sort of error.
Nevertheless, they are frequently touted in financial markets as guides to future action. (If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.)
Indeed, the stupefying losses in mortgage-related securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors.
These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford.
In short, universe “past” and universe “current” had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact.
