10 Highlights of the Financial Crisis Inquiry Commission Interview of Warren Buffett on May 26, 2010

10 Highlights of the Financial Crisis Inquiry Commission Interview of Warren Buffett on May 26, 2010

The recently released 103 page transcript of the Financial Crisis Inquiry Commission Interview of Warren Buffett on May 26, 2010 provided some very interesting insights into the causes of the financial crisis, its consequences on the shareholders of financial institutions, and on stock market valuation.

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(1) Stock Market Valuation – Mr Buffett cites a 1924 book by Edgar Lawrence Smith that concluded that stocks always outperform bonds “when the dividend yield on stocks was the same as the yield on bonds, and on top of it you had retained earnings.” If we were to apply this rule of thumb to today's stock market, the current dividend yield on the S&P 500 of 2.12% exceeds the yield on 10-year U.S. Treasury bond (1.72%), as of the market close on April 8, 2016. Furthermore, a better measure, the earnings yield of the S&P 500 (inverse of the P/E ratio) equals 4.43%. By these measures, stocks should be expected to outperform bonds, at least in the short or intermediate term.

(2) Bubbles – The housing bubble resulted from the almost universal expectation that the prices of houses can only go up.

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(3) Smoothing Earnings – Warren Buffett sold his major stake in Freddie Mac (FRE) when management promised steady earnings growth. This implied potential manipulation of accounting in order to achieve this goal in a cyclical economy. FRE was also starting to invest in the bond of a major tobacco company which had nothing to do with its mission of promoting home ownership.

(4) Moral Hazard – When the Federal Government stepped in to assist many financial institutions through TARP, etc., the shareholders of these companies lost between 90 and 100% of their investment. Bear Stearns stock went from 180 down to 10. This assistance was required to restore confidence in the financial system. Those who criticized the government's actions on grounds of “moral hazard” were wrong, as the equity of these firms was essentially wiped out. Unfortunately, wealthy CEO's were able to walk away while being able to maintain the bulk of their wealth. Mr. Buffett recommends that any company that requires financial aid from the U.S Government should have the wealth of the CEO and his/her spouse wiped out.

(5) Derivatives – Derivatives injected enormous leverage and counterparty risk. The more complex and opaque the derivative, the more profitable it was sell. Lehman had a large derivative book with numerous counterparties.

(6) Leverage – If you do not have leverage, you do not get into trouble. Leverage is the only way a smart person can go broke. If you are smart, you do not need it, and if you are dumb, you should not be using it.

(7) Econometric Models – Models work 98% of the time. They never work 100% of the time.

(8) Opaque – If an investment is opaque, walk away.

(9) Ken Lewis – If Ken Lewis (Bank of America) had not bought Merrill Lynch, the financial system would have collapsed.

(10) United States vs. Europe – In the U.S. during the financial crisis we saved ourselves. By contrast, European countries faced the dilemma of saving other countries.

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David I Kass Clinical Associate Professor, Department of Finance Ph.D., Harvard University Robert H. Smith School of Business 4412 Van Munching Hall University of Maryland College Park, MD 20742-1815 Phone: 301-405-9683 Email: [email protected] (link sends e-mail) Dr. David Kass has published articles in corporate finance, industrial organization, and health economics. He currently teaches Advanced Financial Management and Business Finance, and is the Faculty Champion for the Accelerated Finance Fellows. Prior to joining the faculty of the Smith School in 2004, he held senior positions with the Federal Government (Federal Trade Commission, General Accounting Office, Department of Defense, and the Bureau of Economic Analysis). Dr. Kass has recently appeared on Bloomberg TV, CNBC, PBS Nightly Business Report, Maryland Public Television, Business News Network TV (Canada), Fox TV, American Public Media's Marketplace Radio, and WYPR Radio (Baltimore), and has been quoted on numerous occasions by Bloomberg News and The Wall Street Journal, where he has primarily discussed Warren Buffett and Berkshire Hathaway. He has also launched a Smith School “Warren Buffett” blog. Dr. Kass has accompanied MBA students on trips to Omaha for private meetings with Warren Buffett, and Finance Fellows to Berkshire Hathaway’s annual meetings. He is an officer of the Harvard Business School Club of Washington, DC, and is a member of the investment and budget committees of a local nonprofit organization. Dr. Kass received a Smith School “Top 15% Teaching Award” for the 2009-2010 academic year.
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