Buffett's Bad Bet
The financial genius overestimates the risk of default on insured muni bonds.
The annual report of Berkshire Hathaway, written by investment guru Warren Buffett, always presents a distinctive view of the financial markets. This year, amid the characteristic dollops of down-home humor, Buffett says he was lucky that his offer in 2008 to have Berkshire bail out the municipal portfolios of three bond insurers was turned down. He now thinks insured localities are cruising toward financial collapse.
The logic behind low interest rates in the municipal bond market (and low insurance premiums paid to insure against risk) has been safety. But Buffett does not see the sterling historical record of solid debt repayment repeated in the future. The no-default record, he argues, was largely made when the bonds were not insured. But as they have increasingly become so, the old restraints to default are likely to weaken in these tougher times. "What mayor or city council," he wrote, "is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?"
Buffett concludes that insuring tax-exempts has the look of a dangerous business-one that is similar to insuring natural catastrophes, where a deluge of default rapidly erases years of profit.
It is an interesting argument, propounded by one of the world's most savvy investors. But in this case, Buffett's prognosis is wrong. The bond insurers rebuffed the offer of assistance from Berkshire for the perfectly good reason that they were convinced the municipals were by far the safest exposures the companies had. Those insured bonds did not cause the current financial debacle, but they did suffer the consequences, in terms of depressed market values.
There are several other problems with the Buffett diagnosis. Insured municipal bonds have been a major part of new issuance for well over a quarter-century. Half of the dollar volume of all municipal bonds outstanding is covered by some form of insurance, and that has been the case for several years. More important, state and local debt burdens have been declining over the years, a development that is in sharp contrast with the other sectors of the economy.
Between 1985 and 2008, long-term debt of states and localities went up by 310 percent, which was a little less than growth in personal income. Debt service (annual payments of interest and principal) went up 200 percent. Meanwhile, state and local general revenues grew at about the same rate as personal income, or 320 percent. So, the burden of debt outstanding and debt service has been steadily shrinking.
This performance stands in strong contrast to the private sector over the same interval. The overall debt of households grew by 600 percent, with consumer debt growing by 400 percent and mortgage debt expanding by more than 700 percent. The debt of non-financial corporations grew by 650 percent. In a nutshell, the indebtedness of states and localities grew by half the rate of the private sector.
States and localities, like small businesses and corporations, need access to the credit markets. Accordingly, most of them take considerable care that they and their progeny not default or go into bankruptcy. That's not to say that there aren't lots of problems ahead in the months and years to come. But even in Vallejo, California, where the city's fall into bankruptcy may allow officials to tear up employment contracts, it will not alter the terms of debt repayments. Unlike failed businesses, governments don't just go away.