The Breakdown

Explaining Southern California's economy

Things are getting tense in the municipal bond market

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43318 full

It's hard to tell if this is just general nervousness after a rally or a legitimate reason to worry about an impending wave of defaults on municipal bond debt — something that has basically never happened. But in the span of a few days, billionaire investor Warren Buffett has unloaded $8.25-billion in credit default swaps on muni debt.

Buffett's Berkshire Hathaway sold the CDS to Lehman Brothers prior to the investment bank's epic bankruptcy four years ago, a Chapter 11 for the ages considered by many to be the thing that kicked off the Great Recession. Buffett's CDS amounted to a bet that cities wouldn't default on their debts — a prediction that for the most part has turned out the be true.

However, over the past few months, three California cities — Stockton, Mammoth Lakes, and San Bernardino — have declared bankruptcy. The ratings agency Moody's has stressed that muni defaults are exceptionally rare (as long as the bonds are rated; the Federal Reserve Bank of New York recently noted that unrated defaults happen more frequently, although they're far from common). But Moody's has also announced that it's conducting a review of the debt of cities in California, in light of recent events.

The most successful investor in the world is no longer betting "long" on municipal-bond debt? Moody's says California cities could have degrading credit? Is it time to panic yet?

Maybe not. As the Wall Street Journal points out, investors have been attracted to muni debt of late because the stock market has been a roller coaster and U.S. treasuries have been yielding next to nothing. This has swelled the volume of the market that's now $3.7 trillion.

The state of California also isn't having much trouble selling new debt. This is from the WSJ:

Last Thursday, California sold $10 billion in short-term notes in the biggest municipal debt sale year to date. The offering saw strong demand from large investors, and California was able to borrow at rates of 0.33% and 0.43% for notes maturing in mid-2013 that will help the state meet its cash flow needs for the current fiscal year.

Bottom line: California successfully solved its cash-crunch issues through the fiscal year by accessing money that was practically free. 

There is one important factor you have to take into account here, however. It's a lesson learned from the San Bernardino bankruptcy, telegraphed by a Michael Lewis article in Vanity Fair from last year. The state of California is looking after its own finances first. Cities are another story.

The state, through moves such as taking back revelopment money to plug a gaping budget gap, has pushed its financial problems down to the cities (cities were using redevelopment money to plug their own gaps). And as Moody's warns, cities may be breaking with a time-honored tradition of always putting bondholders first. For California at least, this changes the dynamics of the municipal bond market.

Moody's anticipates more bankruptcies by cities in California's future. So this tense period for munis is far from over.

Follow Matthew DeBord and the DeBord Report on Twitter. And ask Matt questions at Quora.

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