WARREN BUFFET’S JOURNEY THROUGH MUNILAND – WHAT SHOULD WE THINK?
There have been a lot of discussions over the last couple weeks about Warren Buffet terminating $8.35 billion in credit default swap protection he had sold on municipal debt and what that means for the municipal market. This trade represented half of his investment in muni CDO’s. It is unclear which municipalities he sold contracts on and what his selling/buying prices were. We do know that, by having sold this swap protection in 2007, Buffet was betting on the perceived credit quality of municipal bonds to improve in the coming years, and that there would be fewer municipality defaults. His plan would then be to buy the contracts back, hoping the cost of the default protection would have gone down, thereby allowing him to make money on this perceived improvement in municipal credit quality. The financial media has decided his willingness to terminate these CDO agreements now reflects a market call on municipal credit quality deteriorating going forward. This must mean, they surmise, he is predicting higher default rates.
If indeed he did assume these contracts in 2007, he has travelled a very painful path. Below is a Bloomberg chart showing CDS spreads for the 46 state index (blue), California (magenta), and Illinois (yellow).
The graph lines tell you the possible story. The value of contracts for the state index in 2007 ranged from 40-50 bps per contract. Remember, if you have sold contracts, to terminate them the investor needs to buy them back. By the end of 2008, the trade is showing huge losses. CDO spreads on the state index were higher at 297 bps (the buyback cost), this is an increase in price by 490%. Since 2008 things have improved. As of August 30, 2012, the state index CDO spread is at 124 bps. This is still a sizeable loss from the initial investment in 2007, but a great recovery from 2008.
What does Mainline West think about the Buffet trade?
Ouch! CDO’s are known as speculative trading vehicles and usually not part of a long-term buy & hold investment. We believe he got this “speculative trade” wrong. Having gone through the pain of 2008, and managing a not so successful monoline municipal bond insurer business (Berkshire Hathaway Assurance Corporation), Mr. Buffet is now ½ finished speculating on the municipal market. He is probably happy he regained some of his losses and is now taking ½ his bet off the table.
Does this mean he is through investing in the municipal markets and believes there are defaults coming? No, Berkshire Hathaway is a large investor in directly owned municipal bonds, and this has not changed. The 10Q SEC filing for year end 2011 showed municipal bond investments of $3 billion. The most recent 10Q for June 2012 shows municipal bond investments of $2.9 billion. One would think if an investor is worried about defaults on municipal bonds, they would be selling their bond holdings. This does not seem to be the case.
In summary, as a buy and hold investor, Buffet appears comfortable with owning municipal bonds. As a speculator in the CDO market, he is frustrated and had enough. We do not blame him. The CDO market for municipal bonds has some structural flaws and issues which keeps many from playing this speculative game. Why would you make an investment betting on states defaulting, when most of them are constitutionally prohibited from filing bankruptcy and payments to bondholders are prioritized above other expenses of the state? Seems like an investment that just moves with market concerns/news and not one based on long-term solid investment fundamentals.
The seasonal effects have continued, but September usually brings a break in this municipal bond rally. The yields along the municipal curve from July 31 to August 31 were virtually unchanged to up slightly, but outperforming taxables. Going into September, the list of uncertainties are growing, and indications of additional municipal supply are starting to appear. Do not expect a quick upward movement in municipal yields, but there could be some signs of market weakness by month’s end. What could bring about this weakness in coming months?
- The upcoming October 15th final tax payment date. This usually creates an outflow of funds from the municipal market.
- Pending infrastructure needs. This may wait until the election, but I know municipalities are already talking about making up for lost time and issuing bond deals before year-end.
- Tax reform? The election may bring some strong words of changes to the tax code. Remember, this is “re-election” talk, not action.
- Fiscal cliff and the need for the US Government to begin trying to balance its budget. This discussion is just beginning. We will have more on its potential impact on the municipal bond market in the upcoming months.
CREDIT QUALITY UPDATE
Municipal Market Advisor Default Trends Analysis (data from MMA) shows the pace of defaults in 2012 to be lagging 2011:
- 49 issuers for a par amount of $880 million have defaulted as of September 5, 2012.
- 79 issuers for a par amount of $1.58 billion this same time last year.
The municipal yield curve and their comparison as a percentage of LIBOR rates highlight how cheap long-term municipals are versus their taxable equivalent and historical yield curve spreads. Click here to review chart and tabular rate details. Our full monthly outlook is available as a PDF. Contact us for your copy.