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A lot of people have become very worried now that Berkshire Hathaway made the move to close out $8 million worth of the municipal credit default swaps that they had. Plus, there are a lot of market commentators and journalists who have been wondering if Mr. Buffett is now sour on municipal bonds altogether. Does he still liked them as an investment vehicle? Should other investors stay away from them as well?

Charles Gasparino brings us the latest bit of speculation on this matter. He believes that the move Warren Buffett made with the municipal credit default swaps had everything to do with political reasons. He believes that Warren Buffett is in a disagreement with President Obama over politics in regards to our country’s welfare system. The truth is that Gasparino’s article in the New York Post is possibly the most convoluted thing ever written about municipal bonds.

Gasparino said “and even if, when you dig deeper, the move suggests Buffett wasn’t making a bet against all munis but only those that adopt some of the same policies he and President Obama are advocating on a national level.”

Gasparino also said that he has been making calls to participants in the market, and he was capable of determining that some of the municipal credit default swaps that Warren Buffett recently closed out were written on the debt of Illinois and California, which are two states that happen to be in really bad shape fiscally.

There is no denying that the states of California and Illinois are cash-strapped right now, and they have some very difficult financial decisions that they must make. The bigger issue is that both states are constitutionally required to prioritize their bondholders. That would make the constitutional provisions which render credit default swaps against the states useless, but only if the entire economy collapses. There is no question that these bonds are definitely going to be paid. It is not possible for a state to declare bankruptcy under federal law.

So the municipal credit default swaps are not actually insurance against states defaulting, but they are a speculative security that can allow an investor to book losses and gains. Buffett publicly announced that derivatives such as credit default swaps are “weapons of mass destruction,” but it didn’t stop Berkshire Hathaway from investing in these securities, even though they get burned by them on occasion.

The best way to truly get a good idea of Warren Buffett’s views on municipal bonds is to take a look at the investment portfolio of Berkshire Hathaway. The truth is that it doesn’t really look like much has recently changed. If you want to look at it for yourself, you will need to go to the “investments in fixed maturity securities” section of their 10Q SEC filing.

By the end of 2011, Berkshire Hathaway had over $3 billion worth of municipal bonds, but if you look at their most recent filing on the date of June 30, 2012, it only dipped a little bit and it’s now $2.9 billion which is only a 4% decline. Since municipal bond yields haven’t done so well, it is very surprising that the decline is not much worse. Berkshire Hathaway really doesn’t get any major benefit from the tax exemption that municipal bonds offer, so it actually isn’t an asset class that will provide Berkshire Hathaway with a great deal of investment income.

If Warren Buffett was completely sour on municipal bonds, he would most likely get rid of all of his cash bond holdings and move that money into U.S. Treasury bonds. Remember, Warren Buffett is a very smart investor, so you have to look at all of the decisions that he makes from a lot of different angles, and don’t just pay close attention to the political narrative.

News came out recently that Berkshire Hathaway and Warren Buffett just canceled $8.25 billion worth of credit default swaps tied to municipal bonds. The experts in this area say that you should not take this as a warning for various reasons.

Stephen Winterstein commented on this exact topic during a webcast interview that he gave with InvestmentNews last Tuesday. He is the managing director at Wilmington Trust Corp. He said “I don’t think Berkshire Hathaway or Warren Buffett was trying to send us a flare to beware the municipal market.”

The CEO of Bernardi securities, Ronald Bernardi, also commented that he didn’t feel like this was a warning at all by Buffett, but most likely an opportunity that Warren Buffett just couldn’t pass up.

Ronald said “We view it as a trade. Mr. Buffett is a very smart man and was astute enough to underwrite insurance against municipal defaults back in 2008 – and he’s had to pay out very little. I suspect he’s made a lot of money on that trade. I don’t necessarily conclude he sold because he’s concerned about massive defaults in the muni market.”

Default Insurance

During the second quarter earnings report of Berkshire Hathaway, they revealed that they actually canceled the credit default swaps, which is a way to have insurance just in case those municipal bonds happen to default, and they did this five years ahead of their schedule. This is information that we learned in a report from The Wall Street Journal.

These particular credit default swaps were initiated by Warren Buffett in the year 2008, back when the issuers of muni bond insurance were struggling.

According to Mr. Winterstein, the biggest change to the muni landscape recently is the vanishing act of municipal bond insurers.

“It used to be humongous; everything was AAA rated. Now it is much more fractured. That makes credit quality the focus,” which Mr. Winterstein mentioned just days before the financial crisis took place.

The biggest shift, according to Mr. Winterstein, is that some AAA rated bonds are now only single A rated. And others have actually dropped as far as triple-B.

He also said that “Credit research is paramount today. An overwhelming amount of municipalities are going to pay their interest and principal back, but there are some land mines out there.”

Does the opportunity to earn 0.1% from your savings account leave you a little bit unsatisfied? How about the thought of only earning 0.2% on your US government two-year treasuries? What about a 10 year municipal bond, paying 1.8% that’s also tax-free? You must think that’s safe.

Well, you need to start thinking again.

A few years back, while in Washington DC testifying about the current state of the United States economy, Warren Buffett actually warned Congress that there is a looming problem that’s going to take place with the US municipal bonds. His exact quote was that it is a “terrible problem”.

Mr. Buffett is once again warns that this crisis is right on the horizon at this point in time.

Let’s Take a Look at Some Brief History 

There was a time when municipal bonds were definitely considered one of the safest investments you could possibly make. When a county, state or even a city decided that they needed to raise some money for something like a project for public works, they would go about doing this by selling these municipal bonds to taxpayers and local companies. When the bonds were do, these places would easily pay them off without any struggle and they would do so like clockwork, because the elected officials in those areas did not want to default when dealing with its own constituents.

Things unfortunately began to change in the 1970s. What happened is the insurance companies decided that they wanted to insure these bonds since they almost never defaulted, and it was a really safe move on their part. They only charged a small premium which would be immediately deposited right back into the bank, and they didn’t have to worry about the municipalities missing the payout for the obvious reasons that were mentioned.

Things Are Quite Different in This Day and Age 

In today’s economy, most of the states and municipalities are unfortunately loaded up with debt, and the stigma and politics of bankruptcy are also not the same any longer.

It’s not such a big deal if the municipalities and states have to default against their voters if they do manage to declare bankruptcy. There are insurance companies all over the world who are going to have to step in and pay these bills because they are contractually obligated to do so since they are ensuring all of the municipal bonds.

There was a report in 2010 that noted that nearly $3 trillion worth of muni bonds are actually insured against default by private companies all over the country.

There is a good possibility that the knowledge that these insurance companies are liable to take care the bill is probably why there were a few different municipal bankruptcies in the state of California over the last month. If you haven’t heard already, Mammoth Lakes, Stockton and San Bernardino have all filed for bankruptcy protection over the last few weeks.

Are Municipalities Still Worried about Filing Bankruptcy? 

Warren Buffett believes that the three municipalities in California probably have started a trend that is going to cause many other places that are in debt to follow suit and file for bankruptcy protection themselves. He actually thinks that this could become a national trend.

Meredith Whitney predicted in 2010 that we would see hundreds of billions of dollars in default. We’re really hoping that this doesn’t come true, and so far it doesn’t look like it’s going to happen. But Buffett sees things differently, and he believes that cities of a relatively big size will begin declaring themselves insolvent because these first cities to file bankruptcy showed that they screwed up, and it hasn’t really caused any negative marks against them as of yet. According to Buffett, “the very fact that they [file] makes it more likely” which means that he thinks other cities are going to follow suit.

How Does This Personally Affect You? 

For some of you this is going to be good news, and other people are going to take this as bad news.

The good news is that you’re not going to end up losing any money as long as the insurers live up to their obligation and pay off the municipal bonds of the municipalities that are going to bankruptcy. But that’s only if this happens the way it’s supposed to work out.

Because the bad news, obviously is that we’re not so certain that the insurers are going to be able to pay off such a large amount of defaulted municipal bonds if it ever reaches that level. Think about this for a second. MBIA, one insurance company of the many that could be on the hook for these municipal bonds, only has $3.6 billion in the bank. That’s obviously not going to pay even close to the $2.8 trillion worth of muni bonds that could potentially go bad. And to make matters worse, MBIA has $13 billion worth of its own debt. Ambac has recently filed for bankruptcy so they’re not going to be covering any of their muni bonds, and Assured Guaranty is only in a little bit better shape than MBIA.

So what’s the bottom line for those bright eyed investors who thought they were putting their faith in “safe, tax-free” municipal bonds? The one thing I can tell you is that your fate really isn’t going to be that good. If more municipalities begin to default and file for bankruptcy, the taxpayers are always going to be the ones left holding the bag. Unfortunately this bag doesn’t have any money in it so don’t get your hopes up too high.