June 2 (Bloomberg) -- Warren Buffett, whose Berkshire Hathaway Inc. has been trimming its investment in municipal debt, predicted a “terrible problem” for the bonds in coming years.

“There will be a terrible problem and then the question becomes will the federal government help,” Buffett, 79, said today at a hearing of the U.S. Financial Crisis Inquiry Commission in New York. “I don’t know how I would rate them myself. It’s a bet on how the federal government will act over time.”

Berkshire’s investment portfolio included municipal bonds valued at less than $3.9 billion as of March 31, down from more than $4.7 billion at the end of 2008. The company had a maximum of $16 billion at risk in derivatives tied to such debt, according to the company’s annual report for 2009.

Buffett, Berkshire’s chairman and chief executive, has previously warned about the risks of insuring municipal bonds. In his annual letter to shareholders in 2009, he said public officials may be tempted to default on bonds whose payments are guaranteed by insurance companies rather than push through needed tax increases. He said guaranteeing municipal bonds against default “has the look today of a dangerous business.”

Local governments rely on the $2.8 trillion municipal bond market to raise money for construction projects and fund other budget items. The financial crisis and recession battered governments across the U.S. by cutting into tax collections and causing pension-fund losses. Some governments failed to set aside enough money to cover retirement benefits promised to employees, which may place increasing strain on public finance.

Rescue for Governments?

Buffett said last month that the U.S. may feel compelled to rescue a state facing default after the government committed $700 billion to bail out financial firms and automakers.

“It would be hard in the end for the federal government to turn away a state having extreme financial difficulty when they’ve gone to General Motors and other entities and saved them,” Buffett told shareholders in Omaha, Nebraska, at Berkshire’s May 1 annual meeting. “I don’t know how you would tell a state you’re going to stiff-arm them with all the bailouts of corporations.”

A report by the Pew Center on the States in February estimated that by the end of the 2008 budget years, states had $1 trillion less than needed to pay for future pensions and medical benefits, a gap the center said was likely compounded by losses suffered in the second half of 2008.

Defaults

About $14.5 billion of municipal bonds defaulted in 2008 and 2009, according to Income Securities Advisor Inc., a Miami Lakes, Florida-based company that publishes a newsletter tracking distressed debt. Many those were securities backed by revenue from nursing homes, property developments and other projects without claim to government tax revenue.

Defaults by local governments with the power to raise taxes are less common. Jefferson County, Alabama, defaulted on more than $3 billion of bonds backed by sewer fees after the deals grew more costly in the wake of the credit crisis in 2008. Vallejo, California, filed for bankruptcy in 2008 after its tax revenue tumbled.

Buffett set up a municipal bond insurance company in December 2007 as competitors, including Ambac Financial Group Inc. and MBIA Inc., struggled to maintain top ratings. Berkshire has scaled back sales as Buffett said the rates that bondholders are willing to pay don’t match the risk.

To contact the reporters on this story: Andrew Frye in New York at afrye@bloomberg.net; William Selway in San Francisco at wselway@bloomberg.net.

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