I started taking notes on Warren Buffett’s testimony before the Financial Crisis Inqiuiry Commission (FCIC). I already posted some of these notes on Guru Focus, I had planned on releasing my notes in four parts but Santangels Review did a great job of transcribing the interview.
I decided to post some of my notes which are very informal. If you want to check them out, they are below:
Hypothesis Bonds v. Stocks … famous little book 1924: Edgar Own Smith .. idea was bonds overperform during deflation and common stock overperformed during inflation … went back and found common stocks always overperformed. Why? Dividend yield on stocks same as yield on bonds but retained earnings factor made stock overperformed. In 1929 … everyone got swept up in that idea and had that great bubble. They forgot original premise that IF stocks were yielding the same returns then … It just happens that pricing action takes over instead of the premise.
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If inflation is going up for 10% a year and interest only 2% … soon you want to get in on the pricing action because if you don’t have the money … who cares you will make more. If everyone gets swept up in the price action … you have a bubble. ESPECIALLY when the housing industry is the largest single asset unit in the country.
Keeps going back to the idea of price action dominating people’s lives (day trading, people making money on internet stocks, and we have had pet rocks and hula hoops … it’s a mindset). Lot of factors contribute, but there is no single answer other than maybe the psychology?
Bought a farm for $600 per acre, farm could produce $60 per acre, but bank had loaned $2000 per acre” … shows the psychology that people can get caught up in the mindset that people think something can “only go up”
Buffet testified he was upset that he was invested in Freddie Mac who made investments in places unrelated to their service and their mission. He claimed they were arbitraging the government’s plans and didn’t trust them.
When asked would the country have been better off without any benefits / bailouts? Moral Hazard? Buffet suggests that no moral hazard exists, lists a few companies that lost up to half a trillion dollars total. Then (answers the question) we would be in a disaster for a long time without government assistance.
Credit default swaps (buffet says derivatives) are financial investments of mass destruction. But started to invest in credit default swaps… says that they have sold insurance for years, but there is nothing improper about basic levels of credit insurance. His concern with derivatives is with the ability to inject enormous amounts of leverage into areas where leverage is dangerous when people don’t fully understand the importance of leverage. Add in people using the leverage to run up assets and receivables … ? Derivatives present big problems.
He wrote a letter in 1982 … and told people then the nonsense was ridiculous that the fed only allows people to borrow a certain level against stocks, but then can gamble (virtually anything) against futures.
Excess risk and excess speculation. Investment vs. Speculation is about intent of the investor. Investment is about looking to the ASSET (house, farm, stock) through the operation of the asset. Speculation is about looking to the price action because you aren’t looking to normal operations, you are looking to what will happen on the price (split, jump, pay a dividend, etc.). He’s looking for returns from the business (investing) not whether the price will go up (speculation).
Regulators didn’t anticipate the bubble as efficiently as they should of, but it’s hard. You don’t want to be crying wolf in 2005, when in 2007 the prices are still going up. You can even become discredited. People will not be inclined to change when easy money is available.
Switched over to next guy:
Most recent shareholder letter on Berkshire Hathaway would never be dependent on kindness of strangers and couldn’t be “too big to fail”
With too big to fail, you will always have them (says Buffet) and they are with Freddie and Fannie … not too big to wipe out the shareholders … not too big to send away the CEO. When asked when the answer is to hold more cash to avoid the too big to fail problem, Buffet says there will always be too big to fail companies. The best way to avoid it is with a board and shareholders selecting the person on top, and that person having something vested in the company.
Buffet likes the ideas of paying executives into forms of stock, and says that new measures are good, but they need to continue with measures to keep in check. Gives an example of a construction company so that if the company goes broke, everyone (managers and decision makers) all go broke as well. With a government controlled company, the people at the top don’t have that risk.
Senior management has gotten significantly more generous in pay in the past 50 years. With more disclosure from the SEC, everyone drives up the price. More information about CEOs drvies up prices “that guy has personal use of company plane … so I want that … AND…”
Mentions a few points on Draconian Measures
Everything follows a ratcheting up affect when it comes to pay of CEOs and such. Buffet states that they don’t have a compensation consultant, but if they do pay their CEOs a lot, it is performance based.
“The nature of Wall street, overall they make a lot of money.” Market systems produce strange results, and capital markets are so big that taking a small percentage of the money still results in huge revenues. That and they aren’t going to give it up.
Most top managers try to align their intentions with shareholders, but they still don’t. He suggests setting up that if a company needs to go to the federal government for help, the CEO and his Wife come away with nothing, and he thinks it would work to change behavior.
Thinks that it wasn’t so much that Goldman Sachs or Wells Fargo needed money, but the system needed support of the government to show that they were going to help. Buffet thinks that it was more important for the government to show that they would do whatever was necessary to help save the system. He never would have invested in Goldman if he would have thought that they needed federal money.
Leveraging cannot “create” problems but can accentuate already existing problems.
Buffet suggest you cannot design (or come close to) a system that would tell them what they were doing with multiple contracts / derivatives and disclosure. So that’s why they got out. If they want to know all of their contract information, they can (they only have 250). But for traders to trade thousands of contracts and know (or think they can count on knowing) what will happen and the mindsets of others … Buffet thinks it’s total nonsense.
Is scared by any of the terms “modernization of the financial markets” … says you open pandora’s box by giving people the ability to invest, speculate or otherwise gamble on long term assets with minimum margin limits and a lot of leverage
Small and community banks will be taken care of by the FDIC, but for large banks you need to have large downsides for failures (management and CEOs)
If you run a bank, it is your job to lay out the lines of credit …
Models may work 95 or 98% of the time, but they never work 100% of the time
Away from derivatives … onto financial crisis:
Primary cause according to buffet is almost universal belief across all life … that house prices would continue to go up. When it goes wrong, then everyone is hit.
“You better not have a system that is dependent on the absence of fraud.”
Any time you make major investments with a lot of money based upon thinking the asset will go up versus the asset producing money, you are in trouble. Once you think that they asset will go up … why look to anything else (company, management, forecasts, market, industry, etc.)
Similar … a realtor who is buying a house that was 250k that went to 500k is more likely to say “buy it now before it hits 750k … “ than saying “don’t do this …” .. so mindsets across all could contribute to the bubble
Homes are very good investments … but don’t go crazy with the idea.
Government programs *could* help as long as the principles are correct (a 20% downpayment, low monthly payments, etc.) But you cannot take a 3% downpayment in a system and allow these defaults to happen and affect the entire system.