Reading the tea leaves on Buffett’s muni trades

Warren Buffett’s Berkshire Hathaway (BRKA) recently terminated credit-default swaps insuring $8.25 billion of municipal debt, according to the company’s latest quarterly SEC filing. The original bet was a bullish one — in the event the municipalities defaulted on their debt, Berkshire would have to pay out. The move to terminate those contracts may have made some investors more skittish about the finances of U.S. states, cities and towns, but this shouldn’t come as a surprise to those who have closely followed Buffett’s remarks.

Since at least 2009, Buffett has warned about the risks of insuring municipal bonds. In his annual letter to shareholders, he said rather than raise taxes to fill budget gaps, government officials might be inclined to default on bonds whose payments are guaranteed by insurance companies. Guaranteeing munis against default, he wrote, “has the look today of a dangerous business — one with similarities, in fact, to the insuring of natural catastrophes.”

Berkshire’s CDS bet comprised just over half of its $16 billion bet on munis, so he hasn’t given up entirely on the public debt market. Still, some have called its termination the second coming of Meredith Whitney’s muni call. The investment advisor warned in late 2010 of widespread muni defaults. Bond prices plummeted following her warning, but have since rallied when her prediction of “50 to 100 sizable defaults” didn’t exactly pan out.

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Indeed, the appetite for munis (and their yields) has been insatiable as the economic uncertainties in the U.S. and Europe continue. The S&P National AMT-Free Municipal Bond index, which measures highly rated bonds, is up 4.9% year to date.

So what explains Berkshire’s latest alert?

For one, it could be the precedent that a rash of bankruptcies in California has set. Municipal defaults are considered rare, but Buffett last month told Bloomberg Television that the stigma has subsided now that sizeable cities – San Bernardino, Stockton and Mammoth Lakes – have all filed for protection within the past few weeks.

Across the U.S., cities and towns have been strained by rising costs of workers, including retiree health benefits and pensions. This comes as revenues that municipalities count on from sales and property taxes have dramatically fallen following the deepest recession since the 1930s.

“Once people find that the city works the next day, it makes it easier for the city council next time they have a problem with pensions – or whatever it is – just to say, ‘Well, we’ll declare bankruptcy,” Buffett added in his interview with Bloomberg.

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Buffett alluded to this back in Berkshire’s 2009 letter to shareholders: “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?”

To be sure, the Oracle of Omaha doesn’t necessarily think the nation is on the verge of hundreds of billions of dollars in defaults, as Whitney had predicted. The scale would probably depend on how the federal government might respond, as Buffett said in 2010 during a hearing of the U.S. Financial Crisis Inquiry Commission in New York: “There will be a terrible problem and then the question becomes will the federal government help.”

Berkshire had been trimming its investment in municipal debt. And its latest move, among other factors, might very well reflect uncertainties of whether the federal government will come to Main Street’s rescue. After all, Washington lawmakers are dealing with their own budget woes in bringing down the U.S. deficit. If Congress can’t agree on how to address the pending “fiscal cliff” before the end of the year, $7 trillion worth of tax increases and spending cuts will begin to take effect in January – a development economists fear could send the economy back into recession.

So if Berkshire this week has deepened worries over munis at all, it really shouldn’t. Buffett has been clear all along.