Buffett Into Municipal Bonds Market

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Hence the call to Buffett's Berkshire Hathaway, with its Himalayan mountains of cash and unassailable triple-A rating. Who wouldn't want Buffett as their insurer? It's a great break for a brilliant investor who managed to be in a strong position when others were weak and now may reap the rewards. Other savvy investors, such as Wilbur Ross, have contemplated joining Buffett in jumping in.

The reason the business can be so rewarding is that government bonds are intrinsically safe: Municipalities almost never default. From 1970 through 2006, only slightly more than 0.1 percent of all muni bonds went bad, according to a large Moody's study. By comparison, corporate bonds in the same period had a 9.7 percent default rate. In other words, corporate bonds are 94 times as likely to fail as muni bonds are.

I asked David Schultz, a professor at the Graduate School of Management at Hamline University, in St. Paul, Minnesota, what he made of Buffett's entry into the muni-bond-insurance business. "First off, I would say it's still a useless product," Schultz said. "Buffett's decision demonstrates that it's probably very profitable. What a great market to get into. Since I think you don't need the insurance, it becomes almost pure profit."

How is it that municipalities almost never default on their debt? When communities face trouble and consider filing a claim on their bond insurance, they think twice. They don't want to risk being downgraded or shut out of the capital markets for future bond sales. It's the same rationale that might keep you from filing an insurance claim if you have a fender bender. You could figure that it's better to eat the cost of the repair than risk having your premium go up.

But bond insurers have it even better than your car insurance company. If you totaled your car, you'd have to submit the claim, future premium increase or not, because you couldn't afford to shoulder the cost of a whole new car. But when municipalities are hit with a disaster or a bridge collapse, they can always get the money from taxpayers. They raise taxes or find other, often draconian ways to stave off default through service cutbacks. The high-finance term for this type of insurance is the free lunch.

So why do the governments buy bond insurance in the first place? Mainly to get the higher credit rating, which lowers the interest rate and reassures investors. The rub, though, is that they should have received lower rates anyway. The municipalities' credit ratings are too low. If rating agencies properly assessed them according to investors' true risk of loss, muni bonds would have lower interest rates without the expense of insurance.

We know this because Moody's has been conducting an epic research project over the past decade to figure it out. The result is a secret decoder ring, provided by Moody's, into which an investor can plug a muni-bond rating. Out pops what the corporate rating would be. According to Moody's table, almost every muni bond would get a higher rating. About two-thirds would probably be triple-A if they were rated with the same criteria used to rate corporate bonds.

The obvious conclusion is that Moody's, as the most influential of the credit-rating agencies, should simply start lifting its ratings on municipalities. But Moody's doesn't have any plans to do that. Why it won't is one of the great mysteries of the muni-bond world. Is it merely a historical artifact? Are the rating agencies plagued by memories of government debacles like the Orange County, California, derivatives blowup or the strike-riddled and garbage-strewn streets of New York during the 1970s budget crisis? According to Moody's, investors and issuers like the system the way it is. But that's not credible. Why would issuers want to pay more than they should? More likely, the system remains unchanged because bond insurance is good for everyone in the market—except for municipalities, that is, but they have no choice except to go along with it.

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