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UPDATE 1-Buffett: US can bail out states, insurers pained

* US will not let ailing state be distressed-Buffett

* Credit raters have low capital needs, high pricing power

OMAHA, Neb., May 1 (Reuters) - Warren Buffett said on Saturday he would expect the U.S. government to bail out an ailing state, and mounted a defense of credit rating agencies as an investment, including stakes by his Berkshire Hathaway Inc BRKa.NBRKb.N.

Speaking at Berkshire’s annual meeting, Buffett said that while he might have in the past overestimated the potential for municipal defaults, this week’s default by a municipal entity whose debt is guaranteed by Harrisburg, Pennsylvania shows they can happen.

Referencing recent federal bailouts of publicly traded U.S. companies, Buffett said it would be hard for the federal government to turn its back on states in distress.

“I personally think it would be very hard, in the end, for the federal government to turn away a state that is having extreme financial difficulties when in effect it honored General Motors [GM.UL] and various other entities,” he said.

Buffett did fret about potential “contagion” in municipal defaults, where a default by one entity could lead to defaults by others.

He said this could be a big problem for bond insurers, especially those that in recent years provided protection on risky mortgage products in the pursuit of higher profits, only to be saddled with enormous obligations as defaults soared.

“The bond insurers, in my view, have extraordinary liabilities in relation to their capital,” he said.

While Berkshire has a bond insurance unit, Berkshire Hathaway Assurance, Buffett said it has done less business than it could because premiums have not been high enough.

Buffett also defended Berkshire's maintenance of its stake in credit ratings company Moody's Corp MCO.N, which has been reduced to below 14 percent, regulatory filings show.

He said rating agencies “made the same mistake” that he, politicians, mortgage brokers and others did in overestimating the health of the housing market.

But he said the agencies, which also include McGraw-Hill Cos' MHP.N Standard & Poor's and Fimalac SA's LBCP.PA Fitch Ratings, have scant capital needs and strong pricing power.

“There is obviously a backlash against rating agencies,” he said. “If they are not forced to change the whole structure around them ... in some dramatic way, it’s a pretty darn good business.”

Buffett reiterated that Berkshire has “never paid any attention” to credit ratings for bonds. “We don’t think we should farm out -- outsource -- investment judgment,” he said.

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