Warren Buffett also has some harsh words in his annual letter (see below) about the creditworthiness of state governments in the US. Perhaps he is simply talking up his latest business venture in insuring municipal bonds, but he does not, as Floyd Norris notes, mention that.

Whatever his motives, the New York Times has a piece this morning on how state governments, including California, are starting to agitate for their bond ratings to be raised because they think they are not being given adequate credit, so to speak, by ratings agencies.

It is certainly a change to find an argument that ratings agencies have been too strict, rather than too lax, in their assessments of borrowers. Yves Smith, however, points out that there is a conflict of interest for agencies because they get paid twice when governments have to get insurance to fix their ratings.

(Correction: I am told by Standard & Poor’s that it only gets paid once and that it adjusts the rating without charge if an issuer gets its bonds insured.)

So who is right, California or Mr Buffett?

 Mr Buffett’s argument is that:

Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement – sometimes to those in their low 40s – and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep.

In contrast, as the Times article puts it:

States and cities rarely dishonor their debts. The bonds they sell to investors are generally tax-free and much safer than those issued by corporations. But some officials complain that ratings firms assign municipal borrowers low credit scores compared with corporations. Taxpayers ultimately pay the price, the officials say, in the form of higher fees and interest costs on public debt.

Actually, I suppose these two arguments are compatible if you accept that state governments are more creditworthy than their ratings in the short-term but are in trouble in the long-term. After all, Mr Buffett is a critic of the US federal government deficit but the US remains a AAA country, at least for the moment.

It is a bit difficult to make a clear judgement given that everyone involved in the debate - Mr Buffett, the ratings agencies, the state governments etc - has a dog in the fight. But I think that the states may have a point, given the recent poor record of ratings agencies.

In any case, it is another argument against the most creditworthy states relying on bond insurance, which seems like a dubious system in the first place, especially since it is peculiar to the US. Surely California ought to have the clout to defy the agencies and insurers?

March 3rd, 2008 in Finance | Permalink