How Safe Are Your Muni Bonds? Not Very, Warns Warren Buffett

Warren Buffett
Warren Buffett

Does the prospect of earning 0.1% on a bank savings account leave you ... unenthused? Do the 0.2% interest rates that the U.S. government is paying on two-year Treasuries stick in your craw? Maybe you're thinking it's smarter to buy a nice, safe 10-year municipal bond, paying 1.8%, and tax-free to boot?

Think again.

A couple of years ago, when testifying in Washington, D.C., about the state of the U.S. economy, billionaire super-investor Warren Buffett warned Congress of a looming "terrible problem" with U.S. municipal bonds.

Now, Buffett is back, and warning that the crisis is closer than ever.

A Little Bit of History

Time was, municipal bonds ranked among the safest investments you could make. Cities, counties and states that wanted to raise money for a public works project would sell bonds to local companies and taxpayers. When the bonds came due, they'd pay off like clockwork -- because no elected official wants to risk defaulting on his own constituents.

Beginning around the 1970s, though, things began to change. Recognizing that muni bonds were a safe investment that almost never defaulted, insurance companies began clamoring for the right to insure the things, charging small premiums and depositing them right in the bank, rarely worried that they might have to pay out.

Busted, Hamstrung ... and Insured

Today, with states and municipalities swimming in debt, the politics of bankruptcy have changed.

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No longer do states and municipalities have to worry so much about defaulting on voters when declaring bankruptcy. Today, they know that in the event of a default, far-away companies with names like Assured Guaranty (AGO) and Ambac Financial -- and yes, Berkshire Hathaway (BRK.A) (BRK.B) -- are contractually obligated to step in and foot the bill in the event of default.

A 2010 report noted that some $2.8 trillion worth of muni bonds were insured against default by private companies.

Chances are, this knowledge is contributing to the recent rash of municipal bankruptcies in California, for example. Over the past month, first Stockton, then Mammoth Lakes, and finally San Bernardino have all filed for bankruptcy protection.

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Inhibitions Evaporate

Whatever the motivation for these cities violating the bankruptcy taboo, Buffett believes that they've started the ball rolling in what could soon become a national trend.

The trend may not get as bad as Meredith Whitney's famous 2010 prediction of "hundreds of billions" of dollars in defaults, granted. But the way Buffett sees it, every time you hear about "very sizable cities like Stockton or San Bernardino" declaring themselves insolvent, the "stigma" of other cities admitting they screwed up and can't pay their bills gets a little bit smaller. "The very fact they [file] makes it more likely" that other cities will follow suit, Buffett says.

What's It Mean to You?

Now here's where we get to the good news/bad news portion of the column.

The good news is that if muni bond insurers prove up to the task of paying what they owe on these bankrupt cities' bonds, people like you and me who bought the bonds should be able to rest easy.

%Gallery-134346%The bad news, obviously, is that insurers' ability to pay isn't exactly certain. Insurer MBIA (MBI), for example, has only $3.6 billion in the bank, which won't make much of a dent if $2.8 trillion worth of muni bonds start to go bad. Also, MBIA has $13 billion in debt of its own. Assured Guaranty is in a little bit better shape, but Ambac has already filed for bankruptcy itself.

What does all of this mean for investors who've put their faith in "safe, tax-free" muni bonds? One thing's for certain: It's not good. If more munis start defaulting, and their "muni bond insurance" policies turn out to be worth less than the paper they're printed on, it's taxpayers who will be left holding the bag. A bag that when peered into, will be found depressingly empty of money.

Motley Fool contributor Rich Smith holds no position in any company mentioned. The Motley Fool owns shares of Berkshire Hathaway and Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway.