Citing the need for additional capacity in the bond insurance market and the desire to move away from the rating system currently used for municipal bonds, California Treasurer Bill Lockyer has proposed using state pension funds to form a state-owned bond insurer.

Mr. Lockyer has been a vocal opponent of the “double-rating” system currently in use by bond insurers, whereby different rating scales are used for municipal and corporate bond issues. Opponents of the double-rating system claim that it drives up borrowing costs for state and local governments by requiring them to obtain bond insurance in order to obtain investment-grade ratings. They point out that even though municipal tax-free bonds have a default rate of less than 1 percent, making them practically risk-free, they aren’t rated as highly as a comparable corporate bond. Rating agencies counter that municipal investors understand their rating method and that such a method allows investors to better compare the risk of the large number of municipal bonds issued each year.

Recently, Berkshire Hathaway Inc. formed a new bond insurance unit that was quickly ushered through the approval process to alleviate a lack of capacity in the bond insurance market. With other bond insurers struggling with the ramifications of the subprime crisis, many municipalities have begun foregoing bond insurance altogether. Mr. Lockyer argues that his proposal would solve this problem by increasing capacity while also avoiding the double-rating system he opposes. Tom Dresslar, Mr. Lockyer’s spokesman, has stated that the California Treasury “won’t have any interest in doing business with Mr. Buffett’s insurance company” as long as it uses the double-rating system. Although there are regulatory hurdles that the state would have to clear in order to own an insurer, Mr. Lockyer appears committed to pursuing the idea unless the ratings regime is changed.