By Maureen Nevin Duffy

State and local government bonds are moving in and out of favor faster than a politician in a bad economy. Claims by Meredith Whitney that governments would default on liabilities sent individual investors running for the exits from late 2010 to early 2011, leaving a $50 billion dent in the market. The dust settled and the market rebounded with dips and rises in sync with news of various public bodies voting to default or consider it. This year investor demand was greater than new bond issues could meet. Then a cold August wind hit with Warren Buffett's $8 billion withdrawal from the muni bond insurance (or muni credit default swap) market and investors seemed to hold their breath.

According to sources, Buffett's positions would have lost money if the credit of the governments underlying the credit default swaps he was holding (not necessarily the credits on other governments in the market) became riskier or if they defaulted. Buffett, who for several years has been vocal about rising risks in municipal bonds, later told Bloomberg Television that the defaults by large California cities were likely to remove the "stigma" of financial failure, and thus ease the way for more governments to follow. 

However the voices of fund and asset managers once again remain strong in favor of muni bonds. And market data appear to back them up. Following Buffett's well-publicized trade, no noticeable change in muni bond or CDS contract trading on government bonds was detected by Markit, an independent data provider that tracks CDS activity. According to a Barron's cover story on August 27, 2012, Buffett's CDS contracts were "bullish bets on state finances." (States are actually doing better financially than America's municipalities, according to the Pew Center research.) Buffett's $30 billion bond portfolio, Barron's wrote, "is light on munis." 

Nevertheless Bill Delahunty, director of Municipal Bond Research for Eaton Vance Investment Managers, questions whether Buffett's comments on Bloomberg should even be taken in the same light as his investment decision. "The states' credit quality is stable at this point." On the local level, a number of credits remain stressed, he says, "but overall (muni) credit remains pretty strong."

Delahunty is more concerned about proposals by the Government Accounting Standards Board (GASB) to increase state and local governments' Annual Required Contribution or ARC, a running tally of how much a government entity owes in benefits versus how much it has or needs to acquire through employer contributions and investment gains. Essentially, the board wants governments to use a lower return calculation of 5.5 percent to estimate its potential returns from investments. They're currently using a rather optimistic 7.5 to 8.25 percent. The lower return assumptions mean the government employers will show that they owe more to their pension funds, at least on paper - on their balance sheets, not in footnotes. 

"The higher reported liabilities will lead to higher ARC's for state and local credits," says Delahunty.  "However, it will be up to the individual state and local governments if they want to fully fund the newly computed ARCs (unless a local credit is part of a state plan, in which case the locals will likely have to fund the ARC at the level the state mandates). The Center for Retirement Research at Boston College has estimated the funded ratios in 2010 for state and local plans would have dropped from 76 percent to 57 percent, under the new GASB proposals, says Delahunty.  He is quick to add that the proposed reporting changes if adopted won't affect the underlying fundamentals or the amount of pension benefits owed today, just the reporting of the liabilities.

But those numbers are staggering in their own right. In Eaton Vance's August 2012 -- US State and Territory Unfunded Pension Liabilities report, the proposed adjustments would increase Moody's unfunded actuarial accrued pension liabilities amount for state and local governments from $766 billion to $2.2 trillion. It's hard to calm your rapid heartbeat by telling it the numbers are only a restatement for reporting purposes.