One of our favorite investors at The Acquirer’s Multiple – Stock Screener is Warren Buffett.

I recently re-read an awesome interview that Buffett did with the Financial Crisis Inquiry Commission back in 2010, where the commission was charged with the task of understanding the causes behind the 2009 financial crisis. Part of this interview includes Buffett’s thoughts on what causes such bubbles. It’s a must read for all investors.

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Here's an excerpt from that interview:

Interviewer:

Thank you. Mr. Buffett we’re with the staff of the Financial Crisis Inquiry Commission. We were formed by Congress in 2009 to investigate the causes of the financial crisis both globally and domestically. And to do a report, due at the end of this year, December 15, 2010 to the President and to Congress which we also plan to release to the American public. We’re tasked not only with investigating the causes of the financial crisis but looking at specific issues that Congress has enumerated in the Fraud Enforcement Recovery Act which formed the Commission. The Commission is a bipartisan Commission, six Democrats and four Republican Commissioners and we are with the staff of the Commission. We wanted to ask you a few questions today and get your views and your insights so that we may better understand the causes of the financial crisis.

What do you think it was, if you were to point to one of the single driving causes behind this bubble? What would you say?

Warren Buffett:

There’s a really interesting aspect of this which will take a minute or two to explain, but my former boss Ben Graham in an observation 50 or so years ago told me that really stuck in my mind and now I’ve seen elements of it. He said you can get in a whole lot more trouble in investing with a sound premise than with a false premise. If you have some premise that the moon is made of green cheese or something, you know, it’s ridiculous on its face.

If you come up with a premise that common stocks have done better than bonds and I wrote about this in a Fortune article in 2001. Because it was, there was a famous little book in 2001 by Edgar Lawrence Smith, in 1924, I think, by Edgar Lawrence Smith that made a study of common stocks vs. bonds. And it showed, he started out with the idea that bonds would over-perform during deflation and common stocks would over-perform during inflation.

He went back and studied a whole bunch of periods and lo and behold, his original hypothesis was wrong. He found that common stocks always over-performed. And he started to think about it and why was that. Well it was because there was a retained earnings factor. They sold, the dividend you got on stocks was the same as the yield on bonds and on top of that you had retained earnings. So they over-performed. That became the underlying bulwark for the ‘29 bubble.

People thought stocks were starting to be wonderful and they forgot the limitations of the original premise which was that if stocks were yielding the same as bonds that they had this going for them.

So after a while the original premise which becomes sort of the impetus for what later turns out to be a bubble is forgotten and the price action takes over. Now we saw the same thing in housing. It’s a totally sound premise that houses will become, worth more over time because the dollar becomes worth less. It isn’t because, you know, construction costs go up. And it isn’t because houses are so wonderful it’s because the dollar becomes worth less that a house that was bought 40 years ago is worth more today than it was then.

And since 66% or 67% of the people want to own their home and because you can borrow money on it and you’re dreaming of buying a home, if you really believe that houses are going to go up in value you buy one as soon as you can. And that’s a very sound premise. It’s related of course, though, to houses selling at something like replacement price and not [unintelligible] of stripping inflation.

So the sound premise it’s a good idea to buy a house this year because it will probably cost more next year and you’re going to want a home and the fact that you can finance it gets distorted over time if housing prices are going up 10% a year and inflation is a couple of percent a year. Soon the price action, or at some point the price action takes over and you want to buy three houses and five houses and you want to buy with nothing down and you want to agree to payments that you can’t make and all of that sort of thing because it doesn’t make any difference, it’s going to be worth more next year.

And the lender feels the same way. Doesn’t really make a difference if it’s a liar’s loan or you don’t have the income or something because even if they have to take it over, it’ll be worth more next year. Once that gathers momentum and it gets reinforced by price action and the original premise is forgotten which it was in 1929.

The internet, it’s the same thing. The internet was going to change our lives, but it didn’t mean that every company was worth $50 billion that could dream up a prospectus and the price action becomes so important to people that it takes over their minds. And because housing was the largest single asset around 22 trillion or something like on about, you know, a household wealth of 50 or 60 trillion or something like that in the United States, such a huge asset, so understandable to the public.

They might not understand stocks or the internet, you know, they might not understand tulip bulbs, but they understood houses. And they wanted to buy one anyway and the financing, and you could leverage up to the sky, it created a bubble like we’ve never seen.

I wish I’d figured that out in 2005.

Interviewer:

This bubble, though, has been described as different from prior housing bubbles.  And certainly the forces that you’ve described about prices and certainly the types of loans that you’ve described have been around for a while. What do you think, though, made this particular housing bubble different and what would you point to the growth of this particular housing bubble? Some have pointed to cheap money, in essence, some have pointed to lack of regulation in the origination business, some have pointed to the drive from Wall Street for securitized mortgages and RMBS and then as collateral for CEOs. Others have pointed to government policy that created the housing bubble. What do you think created and caused this housing bubble?

Warren Buffett:

It’s a great question to which I don’t have a great answer. Why did the, I don’t know whether the tulip bulb bubble was in 1610 or 20 but tulips had been around before and they’d always looked beautiful and people had wanted them in their tables and all that.

And for some reason it gets to a critical mass, this critical point where price action alone starts dominating people’s minds. And when your neighbor has made a lot of money by

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