Buffett On Municipal Bond Risks

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After being asked (well, forced) by Congress recently to testify regarding the credit rating agencies Moody’s and Standard & Poor’s and their role in the last financial crisis, Warren Buffett was also asked what he saw the next big related risk. Buffett’s reply:

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]

It’s no question that many states and municipalities are in big financial trouble. But their municipal bond debt still has relatively low interest rates suggesting that the risk of default is very, very small. No doubt, this is because the historical default rate of municipal bonds is also very, very small. But Buffett points out that in the past, not very many muni bonds were insured by private insurers (such as Berkshire Hathaway). In today’s environment, it is much more likely that a local government will go “oops” and let the insurers pick up the tab. If those dominoes start falling, then a federal bailout will be needed. Then what?

As usual, Buffett summarizes the situation nicely:

“It would be hard in the end for the federal government to turn away a state having extreme financial difficulty when they’ve gone to General Motors and other entities and saved them,” Buffett told shareholders in Omaha, Nebraska, at Berkshire’s May 1 annual meeting. “I don’t know how you would tell a state you’re going to stiff-arm them with all the bailouts of corporations.”

When I wrote about investing in California municipal bonds in September 2009, the yield on the Vanguard California Intermediate-Term Tax-Exempt Fund (VCAIX) was 3.49% and exempt of both federal and CA state income taxes (avg maturity 7 years). Today, it is down to 3.02% with an average maturity of 6 years, indicating a lower overall fear of default.

Still, if you are in the 33% federal tax bracket and 9.55% CA bracket, that 3.49% would be the same as a taxable bond yielding 4.98%. Compare this to the Vanguard Intermediate-Term Investment-Grade Fund (VFICX) which invests in high-quality corporate bonds and only yields 3.70%. Treasuries yields are much lower. For me, the yield difference is so great that it would be hard to not at least consider it as part of my portfolio.

I agree that I can’t see how the federal government will refuse to help bail out the resident investors of states when they’ve already done so many corporate bailouts. But it’s not impossible.

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  1. California should be allowed to fail and be used as an example of how NOT to run a government. The US government is on the same track with no one to bail us all out. I don’t see how the US government (read “We the People”) can be expected to take on the debt of states when right now the deficit is as much as 1.5 TRILLION dollars. Where the hell will the money come from? Printed or borrowed, either way it’s bad.

    You make your bed, now lay in it. If your state (and this is any state) has to file for bankruptcy and default on it’s debts then so be it. At a very minimum, no state should be allowed to receive 1 dime of federal money to stabilize itself until it has taken drastic steps to fix the root cause of it’s problems. And I mean DRASTIC.

  2. I hardly use any soap (lowest line on those little cups that are provided). Plus using cold water saves a ton of money. But it goes beyond just laundry soap, most dish washers only need a tablespoon of soap, not the whole unit being filled. And body soap (a little gross I know) doesn’t need to be POURed onto a loofah to do a good job.

  3. Jenna, I think you have figured out the solution to the state and municipal bond default risk! 😛

  4. Oops…my comment was suppose to go to the blog post below this one… My bad!

  5. One man’s garbage is another man’s gold…. With income taxes going up, the last great tax shelter is the muni bond. That said, the current muni market certainly feels like a bubble.

    Warren Buffet says an asset is worth what someone is willing to pay for it. That theory can finally be reflected in credit ratings based on market prices rather than on the conflicted opinions of Moodys or S&P. But the reality is to expect more muni defaults due to inflated credit ratings, lower tax revenues, budget deficits and headline risk.

    Markets have the intelligence to predict bad news thru market price based rating systems. To see Market Ratings for all all muni bonds go to http://www.bondview.com/marketratings. Its like a Morningstar’s Xray for stocks but instead for muni bonds.

    ???Jim Walker

  6. Buffet has been warning for years to anyone who would listen. Unfortunately those that should listen are sociopaths and only concern themselves with what concerns us to gain political favor, not to solve actual problems.

    Unfortunately State’s receive HUGE federal government assistance right now but most people aren’t paying attention.
    Just a few examples:
    – Military equipment provided to State, County and City Police Departments
    – The 90/10 match on new Medicaid systems
    – Federal grants to State and County agriculture offices. Granted the employees of those gov offices have to apply but most that I know do.
    – and the list goes on and on, watch the news and listen closely…your eyes will be opened.

    Do I agree, not a chance but unfortunately most people don’t care enough to stop the hemorrhaging and will instead complain how the feds aren’t doing enough.

  7. I agree with Robert, peolpe just don’t see the help out there.

  8. I still believe that municipal bonds are a pretty safe option to investing.

    I don’t believe California should not be allowed to default. If a State defaults it does not mean that its debts are going to be wiped. It still has to pay everything it owes + expenses to investors.

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