Warren Buffett’s municipal weapons of mass destruction

August 28, 2012

A lot of ink has been spilled recently over Berkshire Hathaway’s move to close out $8 billion worth of municipal credit default swaps. Journalists and market commentators have wondered whether Warren Buffett has soured on municipal bonds as an investment vehicle and whether other investors should as well. The latest bit of speculation comes from Charles Gasparino, who writes that the move was most likely political and had to do with disagreements with President Obama over the politics of welfare. Gasparino’s piece in the New York Post may be the most convoluted thing that I’ve ever read about municipal bonds:

“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 says that after making calls to market participants, he has determined that some of the municipal credit default swaps that Buffett closed out were written on the debt of California and Illinois, two states in dire fiscal shape.

It’s true that California and Illinois are cash-strapped and facing tough fiscal decisions. But the more important issue is that both states have constitutional requirements that prioritize bondholders. These constitutional provisions render credit default swaps on these states useless because, unless the whole economy collapses, these bonds will be paid. States are also not allowed to go bankrupt under federal law. So muni CDS are not insurance against states defaulting but are speculative securities that allow an investor to book gains and losses. Buffett’s public pronouncement that derivatives like credit default swaps are “weapons of mass destruction” has not stopped Berkshire from investing in, and getting burned by, such securities on occasion.

The place to see Buffett’s view of municipal bonds is Berkshire Hathaway’s investment holdings, and it looks as if nothing has changed much recently. Berkshire reports its municipal bond holdings in the “Investments in fixed maturity securities” section of its 10Q SEC filing. At the end of 2011, Berkshire owned just over $3 billion worth of muni bonds, but according to a filing dated June 30, 2012, the Berkshire portfolio had dipped slightly to $2.9 billion, a decline of about 4 percent. Given how low municipal bond yields have gone, I’m surprised it’s not a bigger decline. An insurance firm like Berkshire gets no benefit from the municipal bond tax exemption, so it’s not an asset class that can provide the firm with that much investment income.

If Buffett were totally sour on muniland, he would likely exit all his cash bond holdings and move to U.S. Treasury bonds. Buffett is a very smart investor, but it’s important to look at his decisions from many angles, not just one that fits a political narrative.

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