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Warren Buffett sounded the alarm bell on the internet bubble, the real estate bubble and the rapid growth of derivatives that contributed to the severity of the financial crisis of 2008. Yesterday, he added the municipal bond market to that notorious list. The LA Times reports:

…at the end of his testimony, Buffett was asked by FCIC Chairman Phil Angelides (who was treasurer of California from 1999 to 2007) what other bombs may lurk behind the credit grades the ratings companies dish out.

Angelides: “In the same way you said there were risks from derivatives, do you see extant risks, current risk, from the model essentially being unchanged from where it was when the mistakes, the [mortgage] disaster … happened?”

Buffett: “Well, the huge question … if I were running a rating agency now, how would I rate states and major municipalities? I mean, if the federal government will step in to help them, they're triple-A. If the federal government won't step in to help them, who knows what they are? If you are looking now at something where you could look back later on and say, these ratings were crazy, that would be the area.

“I don't think Moody’s or Standard & Poor’s or I can come up with anything terribly insightful about the question of state and municipal finance five or 10 years from now except for the fact there will be a terrible problem and then the question becomes will the federal government [help]?”

I imagine that the Feds will be forced to step in to bailout local governments just as they did for the banking system a little over a year ago. I just have a hard time imagining President Obama justifying leaving the states out to dry after giving Wall Street so many billions. BUT… I'm not willing to bet on that outcome. Munis are basically a crap shoot right now and investors aren't being paid nearly enough to compensate for the increasing risk of default.