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Buffett warns (again) on muni bond risks, but what’s your time horizon?

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Warren Buffett took the opportunity Wednesday to repeat his previous warnings about what he believes is a ‘terrible problem’ looming for the municipal bond market.

But how soon a problem? He didn’t get that specific, offering only a general timeline of ‘five or 10 years from now.’

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The billionaire had been called to testify before the Financial Crisis Inquiry Commission on the role of credit-rating firms -- including Moody’s Corp., in which Buffett’s Berkshire Hathaway Inc. is the largest shareholder -- in the mortgage market crash.

But at the end of his testimony, Buffett was asked by FCIC Chairman Phil Angelides (who was treasurer of California from 1999 to 2007) what other bombs may lurk behind the credit grades the ratings companies dish out.

Angelides: “In the same way you said there were risks from derivatives, do you see extant risks, current risk, from the model essentially being unchanged from where it was when the mistakes, the [mortgage] disaster ... happened?” Buffett: “Well, the huge question ... if I were running a rating agency now, how would I rate states and major municipalities? I mean, if the federal government will step in to help them, they’re triple-A. If the federal government won’t step in to help them, who knows what they are? If you are looking now at something where you could look back later on and say, these ratings were crazy, that would be the area.“I don’t think Moody’s or Standard & Poor’s or I can come up with anything terribly insightful about the question of state and municipal finance five or 10 years from now except for the fact there will be a terrible problem and then the question becomes will the federal government [help]?”

Although he got Berkshire in 2008 into the business of offering private insurance on municipal bonds (for municipalities willing to pay for it, of course), Buffett has since sounded extremely cautious about the potential to make money in that area.

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He has made clear that he believes many states and municipalities will be strapped for resources to honor all of their financial obligations down the road -- and that one easy way out would be to default on insured bonds, sticking the insurance provider with the responsibility of making promised interest and principal payments to investors.

“Local governments are going to face far tougher fiscal problems in the future than they have to date,” Buffett wrote in his annual letter to Berkshire shareholders in February 2009 (see pages 13-14). In particular, he cited ballooning pension-benefit liabilities.

“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,” Buffett wrote. “If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow.”

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“Insuring tax-exempts, therefore, has the look today of a dangerous business,” he wrote.

In effect, Buffett fears the same kind of contagion in the muni market that now appears to be spreading among some homeowners who are underwater on their mortgages and who are deciding to simply walk away.
Buffett is right about the frightening pension bills faced by many state and local governments, obviously.

But if he’s also right that this is an issue that won’t come to a head for several years, many muni bond investors can be comfortable taking a Scarlett O’Hara approach toward owning the debt: “I’ll think about that tomorrow.”

And, as he also notes, if this is the next big federal bailout, muni investors may not have much to worry about, anyway.

-- Tom Petruno

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