Get Ready for Great Recession, Part 2

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Harrisburg files for bankruptcyThe capital of Pennsylvania just fell into bankruptcy. What? You didn't hear? Neither did the financial markets -- yet.

Crippled by a $300 million-plus debt burden taken on to fund a municipal incinerator, Harrisburg, Pa., filed for bankruptcy protection earlier this week. According to its city council, the only alternative to bankruptcy would have been to sell off the city's few remaining cash-generating assets -- parking garages and parking meters, for example -- to raise funds to pay off its creditors. Worse, once those assets were gone, the city would have been even more strapped for cash, which probably would have necessitated a bankruptcy filing "in three to five years anyway." So rather than procrastinate, Harrisburg bit the bullet -- and bit the big one.

The Shocking Reaction -- Yawn

The day after news of Harrisburg's bankruptcy broke, the Dow Jones Industrial Average (^DJI) barely trembled, while the Nasdaq (^IXIC) actually rose 0.6%.

And what about the one company that you would think would have been slammed by the news, Assured Guaranty (AGO) (whose subsidiary insured part of Harrisburg's debt and will now almost certainly be asked to pay up in the bankruptcy proceedings)? Its stock didn't even budge!

Clearly, most investors don't think the city's bankruptcy is a big deal. But two of the smartest investors in the room disagree.

The Woman Who Saw This Crisis Coming

On Oct. 31, 2007, Oppenheimer analyst Meredith Whitney became instantly famous when she broke the conspiracy of silence on Wall Street and warned investors that Citigroup (C) was on the verge of insolvency.

Derided for her pessimism, Whitney was all too quickly proved right, as America's banking establishment imploded, and the nation descended into the Great Recession.

Late last year, Whitney -- now running her own shop -- gave the gong of doom another sharp rap when she predicted the next big crisis. Appearing on CBS' 60 Minutes in December 2010, she predicted the U.S. would see anywhere from 50 to 100 local and municipal governments default on their bond offerings in 2011, causing "hundreds of billions" of dollars worth of losses for bond investors, and for shareholders in the multiple private companies that have insured the muni bonds.

Happily, this so far hasn't happened. According to Lipper Research Services, only $1.1 billion worth of America's $3.7 trillion in municipal bonds have defaulted this year.

But that doesn't mean we're out the woods yet. At least, not according to one oracle.

Guess What Keeps Warren Buffett Up at Night?

Warren Buffett was asked to opine on future risks to the U.S. economy when he appeared before Congress last summer to give testimony on the role that Moody's (MCO) and McGraw-Hill (MHP) subsidiary Standard & Poor's played in the financial crisis.

Would you care to guess whom Buffett named as Public Enemy No. 1 to the U.S. economy? That's right: The municipal bond market. Here's what the Oracle of Omaha had to say about it:

If you are looking now at something where you could look back later on and say, "These ratings were crazy," [municipal bonds] would be the area. I don't think [Moody's or S&P] or I can come up with anything terribly insightful about the question of the state and municipal finance five or 10 years from now except for the fact there will be a terrible problem and then the question becomes: Will the federal government bail them out?

Burned once by criticism of its TARP bailouts, and more recently by taxpayer outrage over government grants to failed solar panel producer Solyndra, the odds of the federal government bailing out desperate municipalities look doubtful. I suppose it could happen, if the situation turned grim enough. But Buffett has never been one to leave investments to chance.

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Weighing the risks, his Berkshire Hathaway (BRK-A) (BRK-B) has been ratcheting back its exposure to municipal bonds. In 2008, Berkshire insured nearly $600 million worth of new municipal bond issuances. By 2009, Berkshire backed just $40 million of new issues.

What's got Buffett feeling so moody about munis? Take your pick. Runaway entitlement spending. Massive unfunded liabilities in public pensions. It all adds up to state, local, and municipal governments that are in hock up to their eyeballs, and ready to follow Harrisburg down the rabbit hole when and if another economic shock hits.

How Big Is the Risk?

Could this happen in time to produce Meredith Whitney's "hundreds of billions" of dollars of losses this year? It's hard to say.

On the one hand, municipal bonds today are paying interest rates about 20% higher than U.S. Treasury bonds. This suggests the market has priced in the risk. On the other hand, with the U.S. economy not exactly out of the woods, but at least no longer in free fall, you don't hear much in the media lately about the risk of muni defaults. (Aside from, you know, stories about the occasional mid-Atlantic state capital filing for bankruptcy.)

But it could be there are other trees out there in the forest, just waiting to fall -- and we just haven't heard about it yet.

Motley Fool contributor Rich Smith does not own shares of any companies named above. The Motley Fool owns shares of Citigroup and Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Moody's and Berkshire Hathaway and writing puts in Moody's.

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