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Dateline: Dow 10,000 and change.
With the stock market finally bouncing back from its double-digit percentage drop, investors want to know: Was that the long anticipated "technical correction"? Is it over, and are we now headed back into a sustained bull market?
According to two of the sharpest minds in investing -- Warren Buffett and George Soros -- the answer is no, the bull is not back. To the contrary, "Financial Crisis, Part II" may be coming soon to a theater near you.
Something wicked this way comes
Testifying before Congress last week, Buffett warned that we could be standing on the brink of the next financial crisis. A brink which begins, as it turns out, right at your city limits.
Congress had asked Mr. Buffett to testify about the role that credit raters Moody's (NYSE: MCO ) and Standard & Poor's played in the last financial crisis. But in the course of doing so, lawmakers couldn't resist the urge to pick Buffett's brain. And so it was that Financial Crisis Inquiry Commission chairman Phil Angelides asked: Where's the next big risk to our economy? Buffett's reply:
If you are looking now at something where you could look back later on and say, "These ratings were crazy," [municipal bonds] would be the area. I don't think [Moody's or S&P] or I can come up with anything terribly insightful about the question of the 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 bail them out?
Buffett's backing up his views with actions. In 2009, Berkshire only insured $40 million in new muni bond issues versus a whopping $595 million than in 2008. So if you were wondering why you're hearing how so much state and municipal debt has been "sold short" by way of credit default swaps in recent months, then you have an answer: Investors think munis are going down.
Roadmap to the next bailout
How did the states and municipalities get in their current fix? Take your pick(s): Runaway entitlement spending. Massive unfunded liabilities in public pensions. In short: Debt loads that more resemble a mountain than a molehill. Unless something happens quickly to slow and reverse the tide, we're going to see a lot of states and municipalities go broke. In fact, up in Rhode Island, one town took the unusual step of having a receiver appointed, as an alternative to bankruptcy in a state that doesn't allow towns to file for it.
Of course, the governments that issue muni bonds will tell you this is all just bunk. They'll cite historical statistics showing that municipalities hardly ever default, and argue that their bonds should enjoy high ratings from the raters to reflect that fact.
But here's the thing -- quoting now from Buffett's letter to shareholders in Berkshire's 2008 annual report: "[T]hat record [of low default rates] largely reflects the experience of entities that issued uninsured bonds. Insurance of tax-exempt bonds didn't exist before 1971, and even after that most bonds remained uninsured." Indeed, as recently as 1980, only 3% of new bond issues were insured; by 2007, that number had climbed to 60%. Today, more than half the estimated $2.8 trillion worth of municipal bonds floating around out there carry some form of insurance.
As for who's doing the insuring, the biggest player in the municipal bond insurance industry today is Assured Guaranty, but there are several others. Berkshire Hathaway (NYSE: BRK-B ) , of course. But also, CIFG Assurance, Syncora Guarantee, and specialized subsidiaries of Ambac Financial (NYSE: ABK ) , PMI Group (NYSE: PMI ) , and MBIA (NYSE: MBI ) all play a role here.
Playing with fire
But if you are considering playing in this market, beware: You could get burned. You see, it used to be that default by a state or municipality would mean massive losses for the "citizens and businesses" who had bought those bonds -- "citizens and businesses" who often were the very taxpayers who supported the local community.
When a government's default threatened to ruin its own citizenry, that made for a strong disincentive to do so. But the same doesn't hold true when there's a far-away insurer with (presumed) deep pockets backing the debt. Sure, California might balk at the idea of stiffing its own citizens. But default and let MBIA and Ambac pick up the tab? Why not?
As Buffett explains, the introduction of insurers backstopping government spending excess has changed the game. The "belt-tightening, tax increases, [and] labor concessions" he cites as saving NYC from bankruptcy in 1975, for example, are no longer needed. Today, any city or any state that's forced into bankruptcy, and that's already paid good money to have its debt insured, is going to want payback for their bondholders. The insurers will be forced to, in Buffett's words, "share in the required sacrifices."
Don't sacrifice yourself on the altar of municipal excess
According to Buffett, the cost to repair municipal balance sheets today is "simply staggering." George Soros agrees. Discussing the related issue of massive short-selling of collateral default swaps back in April, Soros warned that: "Going short on bonds by buying a CDS contract carries ... almost unlimited profit potential."
That's great news for the hedge funds that invest in such things. It's pretty good news, too, I suspect, for banks like JPMorgan Chase (NYSE: JPM ) and Citigroup (NYSE: C ) , that have been making a market in selling municipal CDS lately. But for investors in the debt insurers themselves and the taxpayers who may be called upon once again to bail 'em out, it's nothing short of The Next Financial Crisis. And it's coming soon to a town near you.