When Warren Buffett’s Berkshire Hathaway announced recently that it had extracted itself from a big bet insuring a massive amount of municipal debt from default, the move brought attention to a relatively sleepy part of the market.

Reflecting a lack of liquidity as much as concern about the potential for defaults, spreads in the $60 billion municipal credit-default swaps market have been wide for some time, market watchers say.

But the Berkshire trade, sound technicals and a recent industry move to standardize contracts might increase interest in muni CDS, which has suffered from apathy on the part of investors and a lack of price volatility to attract traders.

Many in the industry have said the Berkshire move should not be interpreted as pessimism on Buffett’s part about the muni market, where headline risk has increased due to several high-profile municipal bankruptcies and predictions about more bond defaults. But such a large transaction could bring more attention to the muni CDS market, said Mikhail Foux, a municipal analyst at Citi.

“It could help the liquidity of muni CDS,” he said. “There could be no effect. But if there’s going to be a positive effect, we’re going to see it in the fall, when people realize that the technical is not there anymore. Spreads are still cheap; fundamentals of the space are still pretty good, with certain exceptions. Why wouldn’t you take some exposure?”

Muni CDS spreads have skyrocketed over the past several years. As of early September, spreads for the Markit benchmark 10-year muni CDS index, MCDX, have climbed 167 basis points to 215 since its inception in May 2008, when it recorded a spread of 48.

Muni credit-default swap spreads widened in 2009 initially. They also did in 2010, due to credit concerns about municipal bonds that failed to materialize. They have yet to really tighten.

As the MCDX numbers represent the cost of buying protection against default, higher spreads mean it has become more expensive to buy such protection. For example: a 250-basis point spread for a state CDS means it would cost $250,000 per annum to buy protection on a $10 million notional amount of that state’s debt.

The Berkshire deal involved more than 13% of the muni CDS market, and upward of 30% of the single-name sub-group therein, Foux estimated.

Lehman Brothers in 2007 bought $8.25 billion in single-name muni CDS from a subsidiary of Berkshire Hathaway covering general obligation debt issued by 14 states.

But because of the sheer size of the contracts and the relative illiquidity of the single-name muni CDS market, the Lehman debtor-in-possession couldn’t make money trading them.

They managed to unwind the CDS with Berkshire. The company announced in its second-quarter filing that it had completed the termination of the state and municipality CDS contracts, most likely making a loss, according to someone familiar with the deal.

Berkshire still has roughly $8 billion in exposure to state and local credits through other existing insurance agreements.

The muni CDS market has been quiet for some time. Much of that is due to its relative illiquidity, a muni analyst in New York said.

For one, the muni CDS market isn’t very deep, with few brokers quoting them, he said. Also, they’re not widely utilized because the real-money buyer doesn’t have a lot of interest in the product.

“There’s a really limited global macro audience, which is effectively what this market would need,” the analyst said.

In addition, there’s a taxable consequence for muni CDS. Investors must pay taxes on a trade that results in a gain, he said.

“A lot of funds and traditional munis, you can’t do that inside the prospectus,” the analyst said. “So, you’re left with a bit of an illiquid market.”

And though activity has slowed, of late, there’s been more interest with trades in the MCDX index than in individual muni CDS names, according to John Hallacy, a municipal research strategist at Bank of America Merrill Lynch.

But muni CDS liquidity could well increase for a number of reasons, Foux noted. For one, earlier in the year the International Swaps and Derivatives Association implemented new rules to align the muni bond CDS market with those that already exist for corporates and sovereigns to make muni CDS less risky and more efficient for investors.

This included new auction-settlement terms, a resolution committee and a common standard effective date for muni credit-default swap transactions.

Thus far, though, market watchers differ on the degree to which the changes have affected the market. “Ironically, when they made that move to standardize the contracts several months back, they thought it would increase activity,” Hallacy said. “But it seems to have had the opposite effect.”

But Otis C. Casey 3d, director of credit research at Markit, said the recent industry move to standardize U.S. municipal CDS contracts has already had a positive effect on the market. “There was a noticeable increase in liquidity immediately following the changes in the Markit MCDX index, for example,” he said.

Muni CDS spreads remain cheap when compared with sovereigns and high-grade corporates, Citi’s Foux said. And in this, muni CDS can be viewed as an opportunity.

Also, the lack of liquidity, and not faulty fundamentals, lies behind the reason for the wider muni CDS spreads, he said. But if liquidity improves, Foux added, spreads should tighten and thus present an opening to go long. It boils down to figuring out the timing.

Although Casey said that it’s difficult to say whether there is any “notoriety benefit” from Buffett’s involvement in muni CDS, he remains confident about the market’s health.

“It goes without saying that sound technicals help liquidity in the market for any financial instrument,” he said.

For the New York-based muni analyst, it would take a large selloff in muni yields to the tune of 75 to 100 basis points to bring more investors into the muni credit-default swap space.

“If we backed up in a violent move, you might see different players then get involved in that market because they think they could strip out some total return,” he said. “But the way the market is currently, with its lack of volatility and supply-demand imbalance, it doesn’t lead a lot of people into that type of trade.”

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