March 28 (Bloomberg) -- Billionaire Warren Buffett's new bond insurer may not get any business from California, the largest U.S. municipal debt issuer.

California Treasurer Bill Lockyer is leading more than a dozen state and local governments that say bond ratings exaggerate the risk of default, pushing up interest costs and forcing issuers to buy unneeded insurance. Lockyer said in a March 26 interview his state will shun Berkshire Hathaway Inc.'s venture because Buffett's company supports the current ratings.

``It's unfair to taxpayers,'' said Lockyer, who estimates the present system may cost his state an extra $5 billion over the next three decades. ``I hope Mr. Buffett will rethink that viewpoint. I don't intend to do any business with his firm.''

Berkshire Hathaway Assurance was created in December after state regulators sought to help governments get coverage when losses jeopardized bond insurers MBIA Inc. and Ambac Financial Group Inc. The turmoil spread to auction-rate markets, where average debt costs almost doubled from January to more than 6.5 percent as of March 19. Instead of embracing Buffett's company, some bond issuers began asking why they need insurance at all.

Lockyer is urging the California Public Employees Retirement Fund and the California State Teachers' Retirement System, the two largest U.S. public pension funds, to help start a rival to Buffett's new insurer. The funds, with a combined $415 billion in assets, already guarantee municipal issues through letters of credit. Lockyer sits on the boards of both funds.

Defaults `Extremely Rare'

In criticizing the bond insurers and rating companies, elected officials and lawmakers point to a study by Moody's Corp., the credit-rating firm in which Berkshire is the largest shareholder, that found only 41 defaults in 37 years. Missed payments are ``extremely rare,'' Moody's concluded, prompting states including California and Connecticut to demand changes in ratings systems to reflect the low risk.

Moody's and Fitch Ratings have said they may adopt a single scale for both corporate and municipal obligations, which include $2.6 trillion of insured debt from state and local governments. The change would boost ratings for municipalities and undercut demand for Omaha, Nebraska-based Berkshire's new insurer, said Ajit Jain, who heads the unit. Berkshire won a license this week from California's insurance regulator to begin covering municipal bonds in the state.

`Little Need'

``If the ratings agencies level the playing field in terms of how they rate municipal versus corporate obligations, there will be little need for a financial guaranty insurance marketplace,'' Jain said in prepared testimony for a U.S. congressional hearing this month. Jain declined requests to comment for this article and Buffett didn't respond.

The Moody's report, published last year, focused on defaults from 1970 to 2006 tied to bonds Moody's had rated. It found distressed governments are almost invariably bailed out before they miss payments.

Lower-ranked munis performed better than the best company bonds. Corporate debt with Moody's highest rating had an average 10-year cumulative default rate of 0.52 percent between 1970 and 2006, compared with 0.13 percent for munis carrying the fourth- highest rating.

That means every U.S. state except Louisiana would receive AAA status if their bonds were rated using the same standards as corporations, Moody's said.

Desert Water

``We're selling water in a desert; we should be rated to reflect that,'' said Cary Casey, who oversees bonds at the Southern Nevada Water Authority in Las Vegas that have a AA+ rating from Standard & Poor's. Casey said he's not interested in Buffett's insurance. ``He's no savior.''

The first municipal bond insurance policy was sold in 1971 by Ambac. The near bankruptcy of New York City in 1975 bolstered demand for the industry, said Richard Larkin, research director at brokerage Herbert J. Sims & Co. in Iselin, New Jersey, and a former chief municipal rating officer at S&P.

New York City creditors were paid in full. When Orange County, California, filed the largest municipal bankruptcy in 1994, only one issue defaulted and no principal or interest payments were missed, according to Moody's.

``The legalized extortion has been going on since before I became mayor of Somerville in 1990,'' said U.S. Representative Michael Capuano, a Massachusetts Democrat on the House Financial Services Committee. Capuano said he was forced to buy bond insurance, even though his town of 80,000 had never defaulted and the state provided backup guarantees.

Cutting Cops

``It was small money, but I was laying off cops, firefighters and teachers,'' he said in an interview.

Representative Barney Frank, also a Massachusetts Democrat and chairman of the same House panel, called muni ratings ``ridiculous'' during a March 12 hearing and gave the ratings firms a month to revise the system.

Current methods reflect investor demand for a way to gauge the relative strength of issuers, which would be lost if most municipal ratings were AAA or AA, said Gail Sussman, managing director for public finance at Moody's. Muni ratings haven't incorporated the possibility of recovery for a bond in default, which a corporate rating does, she said.

Standard & Poor's, a unit of New York-based McGraw-Hill Cos., has denied any disparity in the way it rates debt.

Connecticut Attorney General Richard Blumenthal is pursuing an antitrust probe of ``possible agreements or understandings among the credit-rating agencies with the bond insurers that have maintained and supported the dual rating system,'' he said in an interview. He called the split ``irrational and unjustifiable.''

State Backing

One of the bonds Berkshire insured, and that Moody's subsequently rated AAA, was issued by the cash-starved Detroit city schools. Even those don't need insurance because Michigan guarantees most school bonds, said Louis Schimmel, who has advised the state on keeping distressed municipalities solvent.

Buffett's company ``is coming in to save something that doesn't need to be saved,'' Schimmel said. ``By the time you get to Warren Buffett, the risk is zero.''

To contact the reporters on this story: Josh P. Hamilton in New York at jphamilton@bloomberg.net; Christine Richard at crichard5@bloomberg.net

Last Updated: March 28, 2008 11:13 EDT