The Second Sign of the Muni Bond Apocalypse

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Warren Buffett is called the Oracle of Omaha, and with good reason. Like an oracle, he deftly dodged the dot-com bubble, while speculators derided the super-investor for not understanding the "new economy." A few years later, in 2005, he dubbed derivatives "financial weapons of mass destruction" well before the current financial crisis hit and positioned his company Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) accordingly.

So it's only with great nerve that anyone calls out Buffett on the next financial craze, but so it is. And this time it's about the municipal bond market, which Buffett has called a "terrible problem." I call Buffett's prediction the first sign of the muni bond apocalypse. The second sign is the denials that inevitably follow the predictions of the wise.

"When it comes to municipal bond defaults, both Warren Buffett and Meredith Whitney are not only dead wrong, they are out of their league," said Richard Larkin, senior vice president and director of credit analysis at investment bank Herbert J. Sims. The quote comes from notes sent to CNBC before an interview with Larkin. Whitney has infamously claimed that U.S. cities will face a wave of defaults. Herbert J. Sims is a national underwriter of tax-exempt bonds for senior housing and long-term care providers and specializes in financing projects for the elderly.

Buffett, the most successful investor of all time, out of his league? Sure, it makes a great headline ...

Buffett moved Berkshire into offering private insurance on municipal bonds in 2008, so he's got plenty of info on what's going on. As always, with the move the Oracle was trying to exploit mispricings in the multitrillion-dollar muni market, but he remains none too sanguine: "I don't think Moody's (NYSE: MCO  ) 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]?" Buffett has noted cities' and states' problems with pension-benefit liabilities, which go to seniors.

Buffett has also suggested that municipalities would be inclined to simply default on their obligations to the extent that their bonds are insured by those not living in their communities. That would put further pressure on bond insurers such as MBIA (NYSE: MBI  ) and would hurt underwriters such as Herbert J. Sims. Says the Oracle: "If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow." Later he concludes: "Insuring [munis] ... has the look today of a dangerous business."

So a lot of what happens, according to Buffett, depends heavily on the actions of the federal government. Is Buffett right? He's done quite well so far at dodging bullets.

All this is not to say that Buffett is infallible. He's made his share (smaller, to be sure) of stumbles. Buffett acquired shares of ConocoPhillips (NYSE: COP  ) near the peak of the commodities bubble in 2008. He's had to subsequently sell shares and harvest a tax loss. But with emerging markets expected to continue driving oil prices briskly higher and shares of Conoco, too, Buffett's mistake is probably one of timing, more than anything else. And in 2007 Buffett's investment in two Irish banks, one of which was rumored to be Allied Irish Banks (NYSE: AIB  ) , went sour quickly, to the tune of a 90% loss. And conditions still don't look very auspicious, with Allied Irish effectively nationalized by the government.

But small mistakes like those pale in comparison to Buffett's swift moves during the panic of 2008, when he secured sweetheart deals with Goldman Sachs (NYSE: GS  ) and General Electric. The Goldman deal included $5 billion in preferred shares that paid 10% annually and warrants to purchase Goldman stock that are worth around $2 billion. Some have argued that Goldman should buy back the expensive preferred shares, but the company would be forced to pay a $500 million penalty. So at the most opportune moment, Buffett provided capital and, at least as important, confidence. That was a grand slam from the Oracle.

Even with minor flubs in individual investments, Buffett's been too right for too long on the big shifts in the finance world. Would you have enough nerve to call him out?

Jim Royal, Ph.D., owns shares in Berkshire. Berkshire Hathaway and Moody's are Motley Fool Inside Value recommendations. Berkshire and Moody's are Stock Advisor picks. Motley Fool Options has recommended writing puts on Moody's. The Fool owns shares of Berkshire Hathaway. The Fool owns shares of Berkshire. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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  • Report this Comment On February 11, 2011, at 3:52 PM, EquityBull wrote:

    We will not see a wave of muni bond defaults as Whitney predicts. She is a headline grabber by screaming fire in a crowded theater.

    The government is already talking about bailing out states from their debt caused by pensions by allowing them to not make payments back to the fed gov't. The money will trickle down to municipalities who are currently seeing improved conditions.

    Municipalities will also beging consolidating. Right now the single township model with full support staff is not sustainable. Towns need to be efficient and combine with neighboring towns their offices, fire, police, etc and can drastically cut expenses without sacrificing services. There is no reason for every town to have their own separate infrastructure. It is complete madness. When forced, towns will move in this direction and slash and burn expenses and thus not default.

    Buffett says you always pay more for a cheery consensus. Well with the fear in muni's perhaps now is the time to be buying and not selling. Also if one does just an hour of due diligence they can find out what the bond's ability to repay looks like. All bonds are not created equal.

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