A decision made by Warren Buffett during the third quarter of 2012 to terminate credit default swaps insuring $8.25 billion of municipal bonds has raised questions as to why he has done this. This information was revealed in a recent 10-Q filing with the Securities and Exchange Commission. Buffett sold these credit default swaps five years ago, just prior to the financial crisis. They had another five years to expiration, but Berkshire had the option of exiting from them at this time.
One plausible explanation for Berkshire’s exit from these positions at this time is Buffett’s perception of the increasing risk facing municipalities over the next few years as a result of the weak ongoing economic recovery along with the possibility of another recession.
These credit default swaps were the equivalent of insurance contracts which required Berkshire to pay in the event of bond defaults. These contracts were originally purchased by Lehman Bothers Holdings, Inc. in 2007, more than a year before that firm filed for bankruptcy.
Lehman purchased this default insurance from Berkshire in July, 2007. It covered bonds from 14 states, including California, Florida, Illinois, and Texas. Berkshire received $162 million from Lehman, agreeing to pay Lehman if any of the states defaulted on their debt over 10 years. Berkshire was apparently anticipating that its total payments, if any, would be less than the $162 million it received. There have been no defaults among the among the $8.25 billion in municipal bonds that were insured by Berkshire. As a result of the financial crisis, the cost of insuring the states from default is now much higher.
I was quoted in a Wall Street Journal article (August 21) on this topic:
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.
The entire article is available at:
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