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.