The Blog

Buffett, Bonds, and Bailouts

9:05 AM, Mar 3, 2009 • By JIM PREVOR
Widget tooltip
Single Page Print Larger Text Smaller Text Alerts

Warren Buffett's annual letter to the shareholders of Berkshire Hathaway is a much anticipated event, as he reaches far beyond the typical CEO's letter to shareholders and addresses topics relevant to many discussions of public policy.

Although Buffett is famous as a one of the world's richest men, the media loves him as he endorses Democrats, including Hillary Clinton and Barack Obama in last year's presidential election. He also takes policy positions, advocating for things such as the inheritance tax that the media think he should oppose because he is rich.

This year's annual letter is just out and, interestingly enough and perhaps inadvertently, Buffett's letter contains an insight relevant to government bailout efforts of autos, banks, and other industries, both in terms of their costs now and of the future cost of such current efforts.

Buffett writes about Berkshire Hathaway's entry into the business of insuring municipal bonds. He explains that although this has historically been a very safe sector, the very fact that insurance now exists will make it more dangerous in the future:

The rationale behind very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely reflects the experience of entities that issued uninsured bonds. Insurance of tax-exempt bonds didn't exist before 1971, and even after that most bonds remained uninsured.

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let's go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds - virtually all uninsured - were heavily held by the city's wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city's fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York's citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city's bonds had instead been insured by Berkshire. Would similar belt-tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to "share" in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Local governments are going to face far tougher fiscal problems in the future than they have to date. The pension liabilities I talked about in last year's report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at yearend 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering.

When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop "solutions" less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?

Buffett is right. The existence of insurance creates a moral hazard -- but not just for municipal bond issuers and not just if the insurance is privately issued.Right now every participant in the auto talks, for example, hopes to hold out until Uncle Sam bails them out. They are just waiting to see if they have insurance underwritten by the American taxpayers. If they do, or to the extent they do, why make tough concessions?