Where Buffett Goes, Goldman Follows

Published in Investing on 26 March 2012

Follow the money.

A version of this article originally appeared on our US site, Fool.com.

What do Warren Buffett and Goldman Sachs (NYSE: GS.US) bankers have in common? They both like to make money. (Partial credit to those who answered that Berkshire Hathaway (NYSE: BRK-B.US) is poised to become Goldman's largest shareholder.) So it's no surprise that Goldman is following Mr Buffett into a new activity -- albeit four years later, as Goldman had other things on its mind at the end of 2007. Berkshire showed clever opportunism in entering this industry just as it was entering a period of massive upheaval -- and opportunity. Apparently, Goldman believes Berkshire hasn't picked the tree clean yet.

The "vampire squid" goes fishing

So what business is attractive enough for the masters of the universe at Goldman to dip their toes in the water? The answer is monoline insurance, which consists of providing financial guarantees against the nonperformance of bonds and structured securities (municipal, mortgage, etc). This is similar to credit default swaps, which are insurance against default by a bond issuer, with one critical difference: investors can only purchase a financial guarantee if they have something to insure, so there are no "naked shorts".

"The monolines are bust or close to bust"

Why does Goldman like this business? They're unusually frank about it, stating openly that "part of the reason [issuing financial guarantees] is a potentially interesting opportunity is that the monolines are bust or close to bust".

In fact, some of the monolines did blow up during the credit crisis. As Buffett tells it in Berkshire Hathaway's 2008 Annual Letter (link opens PDF file):

"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."

Without these two attributes, you're dead in the water

As I noted recently in a discussion of the challenges that mortgage REITs face, there are two sources of competitive advantage in any business that involves pricing and bearing risk, whether it be insurance or investment management: Capital flexibility and pricing discipline (ie, a value orientation). In terms of capital strength, Berkshire had it covered:

"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 [Berkshire Hathaway Assurance Company -- Berkshire Hathaway's monoline financial guarantee insurance subsidiary] has become not only the insurer of preference, but in many cases the sole insurer acceptable to bondholders."

Buffett's secret weapon

With regard to pricing discipline, Buffett had a secret weapon in his pocket. Ajit Jain, who runs Berkshire's reinsurance business, took the reins of BHAC. Of Jain, Buffett has said: "He's just a remarkable human being and we are very, very lucky [to have him work for Berkshire]." And, perhaps the greatest compliment of all: "I can't think of any decision he's ever made that I thought I wouldn't have made."

As far as financial flexibility goes, Goldman compares favourably with at least two of the three major monoline insurers, if we go by its credit rating. (Bear in mind that Goldman may conduct this business under a separate entity, which would be higher-rated than the parent company.)

CompanyFinancial Enhancement Credit Rating, Standard & Poor's*
Assured Guaranty Municipal Corp., a subsidiary of Assured Guaranty (NYSE: AGO.US)AA-, outlook stable
Radian Asset Assurance, a subsidiary of Radian Group (NYSE: RDN.US)B+, outlook negative
National Public Finance Guarantee Corp., a subsidiary of MBIA (NYSE: MBI.US)BBB
Berkshire Hathaway Assurance Corp., a subsidiary of Berkshire HathawayAA+, outlook negative
Goldman Sachs**A-, outlook negative

Source: Standard & Poor's. *Long-term, local currency. **Issuer rating.

When it comes to pricing discipline, Goldman is savvier than the monolines -- though certainly less disciplined than Berkshire -- and probably more aggressive with its clients. Either way, a new entrant of Goldman's calibre is hardly good news for monoline insurers. They can expect Goldman to focus on winning the most profitable pieces of business, and Goldman is an extremely tough competitor: its salesmanship and desire to win are legendary -- or, as some might say, notorious.

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