This story flashed across the other day I thought it was very interesting to those attune to the state of municipal and local finance across the country. Everyone remembers Meredith Whitney's famous calls about rampant municipal defaults a while ago which didn't come to pass and she continues to be much maligned for it. Personally, I think she was simply early on the call and considering the deteriorating state of finances across the U.S. she may well be proven right. Well, today it appears Buffet canceled Credit Default Swaps which he sold back in 2008 on approximately $8.3 billion dollars worth of municipal debt.
The paper said the early termination is deepening questions among some investors about the risks of buying debt issued by cities, states and other public entities.The WSJ quoted the source as saying that Buffett's bet that more than a dozen U.S. states would keep paying their bills on time had been made before the financial crisis.
Looking at Illinois whose spreads have blown out phenomenally recently after they failed to address a 43% funded pension liability, leaving them with a +157bps spread second only to Puerto Rico! Figure that out. $47.8 billion dollar holes eventually catch up to you, and much of the market is beginning to worry about this. States are perpetually stretched to the brink and unlike the federal government they can't simply print and borrow to maintain their budgets. Not that I'm rooting for something to happen but it seems that situations like this are becoming increasingly common.
Municipal debt has long been attractive because of the tax exempt status of many issues. GO bonds are backed by the taxing authority thus highly mitigating any risk associated with their default. The issue is that municipalities are stretched more and more with less ability to simply raise taxes to cover shortfalls. Revenue bonds are even worse if the project given goes under (e.g. Harrisburg in Pennsylvania) then your left holding the bag so to speak. It is really a interesting dilemma in an era of reaching for yield combined with the prospect of diminishing agency debt with the shrinking of Fannie and Freddie. Do you guys think Buffet is onto something? Granted, apparently the total size of his bet was $16 billion so he is really just reducing his exposure, but I think more and more a storm is brewing on local debts. Are municipalities the next crisis brewing?
The federal tax exemption allows municipalities to borrow at a rate lower than one which would reflect their actuarial risk premium (whatever that is). Thus, the exposure to default is disproportionate to the underwritten bond, since the federal government is in effect subsidizing municipalities through their creditors.
This is fundamentally the same as what happened with Fannie and Freddie. The GSEs were able to access credit at a lower rate than potential competitors due to implicit Federal support. Thus, they were able to undercut potential competitors and insure MBS too cheaply, which meant lower mortgage rates nationwide. Thus, individuals were able to borrow at rates which did not reflect their risk of default. Scale this across MBS pools, and when Fannie and Freddie they were hit with claims, they were far too exposed.
This means that municipal borrowers, who pay too little for their debt, have an incentive to take out too much debt and exceed their capacity for debt load. Which only makes it more likely that they will default: a vicious cycle.
So, short Munis. Especially if the Bush tax cuts are extended for the top bracket, since this market has the most incentive to invest in tax-exempt bonds.
I can't wait for when Whitney gets the chance to go on CNBC and say "Suck it."
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