Buffett Makes It Official: Municipal Bonds Are Getting Riskier

Today, Warren Buffett stated the obvious about the sad state of local finances in this country when he warned of a coming storm in the municipal bond market. Prepare yourself for a new species of fiscal trouble.

The Sage of Omaha is known for his blunt talk but even by those standards, talking about the "terrible problem" facing municipalities is pretty strong stuff. And no wonder. Such searing recession and slow recovery has taken a whack at municipal revenues. Previous recessions hit one source of local revenue -- sales taxes, property levies or income taxes -- but this one hit them all. It will only get worse as the stimulus package peters out and unemployment remains high. The capital of Pennsylvania, Harrisburg, is teetering on the edge of outright bankruptcy.

This is more than a trivial question for all sorts of reasons, not the least being the $2.3 trillion municipal bond market. That's where you put your money if you want an ultra-safe bet and a way around the IRS, since most munibonds are tax-free. Back when various government officials were scrambling to save the bond insurers in 2008, one key reason was not to tank this massive market. But Buffett dropped a big bomb in his testimony to the Financial Crisis Inquiry Commission when he raised the prospect that the federal government will have to step in to avoid a string of defaults in the municipal bond market, and possibly among the states. The chairman, Phil Angelides, asked Buffet about the risks facing models used by rating agencies (Buffett's Bershire Hathaway owns part of a bond insurer), and this was his response:

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]t's a bet on how the federal government will act over time.

Ratings for U.S. municipalities are no longer a question of whether said locality can meet is obligations in the future. Buffett is assuming -- assuming! -- that many of them will not be able to do so. So if you are trying to measure the risks investors face in buying municipal bonds, you have to wade into the unprecedented question of how much, or whether, the federal government will backstop the nation's towns and cities.

How do you assess the probability that Congress will, in a massive break with the tradition of federalism in this country, start shoveling money directly into towns and cities lest they go bankrupt en masse? In particular, how do you do it in light of the fact that no one (that I've heard of) in Congress is even thinking about municipal finances as a potential problem area into which the feds would have to wade? How much would it even cost?

Richard Ciccarone, head of research at McDonnell Investment Management, which specializes in municipal bonds, told me a few months ago that his firm was already "screening out a lot of municipalities," i.e. steering its clients away from their bonds. Over time, this can only mean higher borrowing costs for localities, or higher premiums to ensure their bonds to the point where they have the coveted AAA rating. Either that, or localities simply make due with fewer sewage treatment plants, incinerators, school renovations and the like.

Unless, as Buffett suggests, the feds step in.

Related:

• Forget the Unemployment Rate -- It's the Long-Term Jobless Who Should Worry Us
• Give It a Rest, Already -- the U.S. is Not Like Greece
• Sneaky: Washington is Passing a New Stimulus Package