Feb 24

Muni Bonds and Chapter 9: Last Year, We Warned with Help from Mr. Buffett

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From the Northwest Quadrant attempts to be an ‘early warning’ blog on issues important to insurance investment professionals.

As Harrisburg contemplates bankruptcy under Chapter 9 and a few other municipalities either have declared or are contemplating per the Wall Street Journal, let’s take a look at the Northwest Quadrant blog (still applicable) from March 1, 2009:

 

So what if Warren Buffett’s annual letter to shareholders says the economy will remain in a shambles through 2009 and probably beyond?   We didn’t need the Oracle of Omaha to tell us things in the economy look ugly.
However, when reading any good narrative, it is important to view the entire tome before drawing conclusions and here is where the popular press has once again missed the boat.. And investors in insured municipal bonds will not like what they see.
Buffett’s Berkshire Hathaway Acceptance Corp is a new entrant in bond insurance, so his group has done more than a passing analysis of the market for insured munis and Mr. B’s basic thesis is centered around poor analytics that sound eerily similar to the simplistic approach utilized for residential mortgages.
“The rationale for very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely refelcts 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.”
So, because we’ve never had big problems with munis, there is little or no chance of that occuring in the future. Just like home prices, right?
“Local governments are going to face far tougher fiscal problems in the future than they have to date.” (He cites pension problems as a large contributing factor…in addition to the recession, of course)”
Warren seemingly pines for the days when New York City declared bankruptcy, but the confluence of interests of uninsured bondholders (many wealthy New Yorkers and institutions with material NYC interests) caused a financial reorganization plan without the use of insurance. Remember the old Municipal Acceptance Corp? Mr. B. then applies this lesson to potential future scenarios.
“When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop ’solutions’ less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents.   Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the change that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?”
“Insuring tax-exempts, therefore, has the look today of a dangerous business – one with similarities, in fact, to the insuring of natural catastrophes. In both cases, a string of loss free years can be followed by a devastating experience that more than wipes out all earlier profits.”
You might say this is all hogwash and posturing on the part of an owner of the only AAA rated bond insurer. However, the logical progression of the argument cannot easily be dismissed. With that in mind, if you or your company own municipals, please don’t think they are safe because they are “insured”, or because after the recent MBIA bifurcation, the insurance is backed by the ‘good insurer’, etc.
Once more, we cannot stress enough that your investment manager review with you the underlying credit of every municipal bond in the portfolio – even GO’s – hello California. And, by all means, feel free to ignore the value of the bond insurance in your analysis.