A decision by Warren Buffett'sInc. to end a large wager on the municipal-bond market is deepening questions from some investors about the risks of buying debt issued by cities, states and other public entities.
The Omaha, Neb., company recently terminated credit-default swaps insuring $8.25 billion of municipal debt. The termination, disclosed in a quarterly filing with regulators this month, ended five years early a bullish bet that Mr. Buffett made before the financial crisis that more than a dozen U.S. states would keep paying their bills on time, according to a person familiar with the transaction.
The insurance-like contracts, which required Berkshire to pay in the event of bond defaults, were originally purchased by Lehman Brothers Holdings Inc. in 2007, more than a year before the Wall Street firm filed for bankruptcy, the person said.
Details of the termination, with the Lehman Brothers estate, weren't disclosed. It isn't clear whether Berkshire's move will leave the company with a profit or loss on the wager. Mr. Buffett, Berkshire's 81-year-old chairman and chief executive, declined to comment.
Some investors said the decision to end the bet indicates that one of the world's savviest investors has doubts about the state of municipal finances. If so, the move could be a warning to investors who have purchased such debt. In canceling the contracts early, Mr. Buffett probably "doesn't want this exposure anymore and is getting out while he can," said Jeff Matthews, a hedge-fund manager who personally owns Berkshire shares.
David Kass, a professor at the University of Maryland's Robert H. Smith School of Business who also owns Berkshire shares, said Mr. Buffett may perceive more risk to municipalities than when Berkshire entered into the positions. Berkshire's move comes as investors are flooding into municipal debt, keeping bond prices high and yields low. An index of highly rated municipal bonds has outperformed government bonds so far this year. Last week, investors poured $964 million into municipal-bond mutual funds, marking 18 consecutive weeks of inflows, according to data firm Lipper.
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.
A relatively low supply of new bonds being issued and ultralow yields on Treasury debt that investors might otherwise consider as an alternative to municipal bonds have kept interest in municipal bonds strong despite numerous warning flags, such as the Chapter 9 bankruptcy-protection filings by three California cities.
Although actual defaults remain rare, analysts said the recent bankruptcy filings raise troubling issues for investors. Stockton, Calif., for example, is proposing large reductions in the payments bondholders will receive as part of its restructuring. Moody's Investors Service warned last week that the "risk of default on municipal bonds in California is rising" due to large budget gaps faced by many cities. A Fitch Ratings report Monday predicts "continued stress for many local governments."
"There is a need for concern,'' said Bill Brandt, chairman of the Illinois Finance Authority and chief executive of Development Specialists Inc., which advises troubled cities and companies. "Many of these municipal leaders appear ready to sacrifice bondholders on the altar of the taxpayers rather than the other way around, which has historically been the case."
Municipal-bond prices tumbled in late 2010 and early last year after analyst Meredith Whitney warned of widespread municipal defaults. When her predictions didn't materialize, municipal bonds rallied. The S&P National AMT-Free Municipal Bond index, a broad measure of highly rated bonds, is up 4.9% year to date.
Bonds issued by cities generally haven't affected debt sold by states, but some states have seen credit-rating downgrades in the past five years due to budget problems or economic weakness.
In July 2007, Lehman bought default insurance from Berkshire on bonds from 14 states, including Texas, Florida, Illinois and California, according to a copy of an agreement between the two companies. Lehman paid $162 million to Berkshire, which agreed to pay Lehman if any of the states defaulted on their debt over 10 years. Berkshire essentially bet that total payouts, if any, would be less than the money it received upfront.
There have been no defaults among the $8.25 billion in municipal debt that Berkshire's swaps insured. The cost of insuring the states from default, however, is now much higher than in 2007, according to data provider Markit. States such as California and Illinois also have lower credit ratings, but Berkshire's exposure to them was limited.
Berkshire still has swaps tied to roughly $8 billion in debt issued by hundreds of cities, states and municipalities. Those contracts can't be terminated before the underlying bonds mature between 2019 and 2054, according to the company. Berkshire also was paid upfront for providing this protection, which was purchased by other financial institutions.
Some investors still see municipal bonds as attractive at the right price. Garey Fuqua, who heads distressed municipal-bond investments at Spring Mountain Capital, said he has been increasing the New York-based investment firm's cash position in anticipation of municipal-bond prices falling.
"We do believe there will be a selloff because of increased interest rates or because of widening of credit spreads," Mr. Fuqua said.