Buffett Into Municipal Bonds Market

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Bond insurance companies, which love the current setup in the relatively risk-free muni business for obvious reasons, happen to be among the rating agencies' best customers. You have to wonder whether the agencies have a conflict of interest that prevents muni-bond-rating reform.

Connecticut Attorney General Richard Blumenthal is starting to investigate this very question, issuing subpoenas over the past few months. "The question is why there are two standards for ratings and why Connecticut towns and cities should be required to obtain bond insurance when the likelihood of default is virtually zero," Blumenthal told me. "Is there conduct that violates the antitrust laws in terms of anticompetitive practices or collusion among rating agencies or the bond insurers?"

Investors in muni bonds like insurance because it lets them buy bonds based on their triple-A rating rather than having to pick and choose from an immense universe of offerings. "Bond insurance provides a way to commoditize the market rather than doing credit analysis and checking each credit," explains UBS muni strategist Kathleen McNamara.

And Wall Street firms like insurance, McNamara adds, for essentially the same reason: They don't have to employ lots of people to check a place's creditworthiness before selling a muni to investors. "It lowers the marketing expenses of the bond when the issuer goes to tap the capital markets," she says. In other words, investors and Wall Street outsource credit analysis to rating agencies—not always the best move, as we've seen elsewhere. Credit-rating agencies have blown the analysis on bond insurers, which is why the market is in crisis in the first place. Well, you win some, you lose some.

How the rating agencies handle municipalities really ought to be a bigger scandal. Think about it: Credit-rating agencies screwed up the mortgage-securities business because they were too lax in their ratings. They're screwing up munis because they are too punitive. In both cases, they manage to benefit from their "mistaken" ratings.

Dinallo should be commended for bringing Buffett in, but it's a Band-Aid. It would be better to eliminate muni-bond insurance for good. That's what makes his January efforts to broker a bailout of the bond insurers ill-advised. The financial guarantors got into this mess by making bad bets on structured finance. They shouldn't be helped simply because they are perceived as vital to an entirely separate market. Regulators should let things play out. If bond insurers go under, so be it. If banks traded with them imprudently, let the banks take their lumps. Instead, regulators should force the rating agencies to bring their muni-bond ratings in line with the rest of their ratings. And they could create a governmental mechanism to back muni bonds in the event of default. Municipalities are effectively the insurers of muni bonds already. Why not make it explicit?

What's nice is that some municipalities are finally figuring this out. In recent months, the states of Wisconsin and California, as well as New York City and 300 other issuers, have sold bonds without buying insurance, according to Bloomberg News, which has been on top of the muni-bond scandal. Cities and states would save billions if they didn't buy insurance but received proper ratings.

So Warren Buffett may not reap his windfall after all. What good news for taxpayers that would be.

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