This is a must read for anyone interested in the economy or investing. Warren Buffett dispenses common sense in large quantities, and he’s especially good at learning from his mistakes – to which he freely admits. I haven’t had a chance to read it yet, and I’ll be interested to see what he says about his investments in Goldman Sachs and GE.
Here’s a link to his annual letter to Berkshire Hathaway shareholders. Read it! I’ll be posting quotes from it and including my comments as I read through it today. I’ll highlight quotes which I feel are especially important. Because I find it hard to read long sections of italics, direct quotes will be in dark blue.
I’ll save this as I go. This will probably end up as a rather long post, so lets get started!
By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.
This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation. Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly.
I think the biggest points here are the massive bailouts, the inflationary impact they will likely have, and the fact that we’re pretty much stuck supporting these companies with taxpayer funds from now on – because our idiot polititians won’t ever vote to take away the money. I also like the “all in” reference.
Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.
While I agree that we would’ve seen a much quicker downturn in the economy last year if the government hadn’t taken action, I disagree in that I think all we’ve done is delayed the inevitable breakdown. And it will turn out that we’ve made it worse by delaying it. Sort of like putting off calling the electric company and telling them that you can’t pay your bill this month. Instead, you wait until they cut off your electricity. Instead of working through the problem and keeping the lights on, you made it worse by postponing the inevitable.
Here’s one of those candid admissions of mistakes I mentioned earlier: During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt. I will tell you more about these later. Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action.
I’m not sure which “dumb things” he’s talking about, but I’m guessing his NY Times editorial telling people to buy stocks now is in the list. It should be anyway.
Buffett has the money needed to invest large sums in long range projects, such as wind energy. Wind farms are capital intensive, and the rate of return is cut dramatically if the owner needs to borrow money to build them. Buffett doesn’t need to borrow to build them, so he makes money long term. Here’s an example.
In 2008 alone, MidAmerican spent $1.8 billion on wind generation at our two operations, and today the company is number one in the nation among regulated utilities in ownership of wind capacity. By the way, compare that $1.8 billion to the $1.1 billion of pre-tax earnings of PacifiCorp (shown in the table as “Western”) and Iowa. In our utility business, we spend all we earn, and then some, in order to fulfill the needs of our service areas. Indeed, MidAmerican has not paid a dividend since Berkshire bought into the company in early 2000. Its earnings have instead been reinvested to develop the utility systems our customers require and deserve. In exchange, we have been allowed to earn a fair return on the huge sums we have invested. It’s a great partnership for all concerned.
That’s an example of investing for the long term. It’s also profitable for both parties (Buffett and consumers) and it’s the way capitalism works. No one was forced to do anything and both sides benefit from the investment.
Some years back our competitors were known as “leveraged-buyout operators.” But LBO became a bad name. So in Orwellian fashion, the buyout firms decided to change their moniker. What they did not change, though, were the essential ingredients of their previous operations, including their cherished fee structures and love of leverage.
Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.
Now he’s getting to the heart of the problem. Companies and individuals took on too much debt – particularly leveraged debt. When jusy one small piece of the structure they built gives way, the whole thing comes crashing down. And there’s no way to avoid it – bailouts and more loans don’t help in the long run.
I like reading Buffett’s annual letter, because you never know what’s coming next. It’s fun to read. Here’s an example where he’s talking about Geico: As we view GEICO’s current opportunities, Tony and I feel like two hungry mosquitoes in a nudist camp. Juicy targets are everywhere. You won’t find stuff like that reading shareholder reports from Fannie Mae or Bank of America. 
He talks about the causes of the housing meltdown in the section about Clayton homes: Lenders happily made loans that borrowers couldn’t repay out of their incomes, and borrowers just as happily signed up to meet those payments. Both parties counted on “house-price appreciation” to make this otherwise impossible arrangement work. It was Scarlett O’Hara all over again: “I’ll think about it tomorrow.” The consequences of this behavior are now reverberating through every corner of our economy.
I don’t know what his solution is, but he mainly has the causes right. The only thing I might add is that he neglected to point out the role of the GSE’s in creating the mess.
Here’s a big chunk of the letter from that section. It’s all good stuff, and it doesn’t do it justice to snip o sentence here and there. Please read it and you’ll be smarter than anyone in our government about housing.
Commentary about the current housing crisis often ignores the crucial fact that most foreclosures do not occur because a house is worth less than its mortgage (so-called “upside-down” loans). Rather, foreclosures take place because borrowers can’t pay the monthly payment that they agreed to pay. Homeowners who have made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away from a primary residence simply because its value today is less than the mortgage. Instead, they walk when they can’t make the monthly payments.
Home ownership is a wonderful thing. My family and I have enjoyed my present home for 50 years, with more to come. But enjoyment and utility should be the primary motives for purchase, not profit or refi possibilities. And the home purchased ought to fit the income of the purchaser.
The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.
Again, good, common sense stuff. And it goes along with my contention that we should let the people who bought houses they couldn’t afford go into foreclosure. And the companies who loaned them the money should go broke. No more bailouts.
This next section is also a must read in its’ entirety. It sounds like many parts of Atlas Shrugged.
This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.
Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.
Today’s extreme conditions may soon end. At worst, we believe we will find at least a partial solution that will allow us to continue much of Clayton’s lending. Clayton’s earnings, however, will surely suffer if we are forced to compete for long against government-favored lenders.
That’s how government inference in the market causes private industry (capitalism) to disappear. That’s how government – using our tax dollars – decides who will succeed and who will fail. It’s “pull” in Washington DC that counts, not the strength of your company or ideas. It’s socialism, fascism, communism or some other “ism” – but it’s most assuredly NOT capitalism.
His letter then moves on to talking about bond insurance, and how the insurers – AMBAC and MBIA being the two largest- got into trouble.
By yearend 2007, the half dozen or so companies that had been the major players in this business had all fallen into big trouble. The cause of their problems was captured long ago by Mae West: “I was Snow White, but I drifted.”
The monolines (as the bond insurers are called) initially insured only tax-exempt bonds that were low-risk. But over the years competition for this business intensified, and rates fell. Faced with the prospect of stagnating or declining earnings, the monoline managers turned to ever-riskier propositions. Some of these involved the insuring of residential mortgage obligations. When housing prices plummeted, the monoline industry quickly became a basket case.
Another insightful section: Indeed, the stupefying losses in mortgage-related securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford. In short, universe “past” and universe “current” had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact.
Berkshire got into the bond insurance business last year, and Buffett has this to say about their operations: A final post-script on BHAC: Who, you may wonder, runs this operation? While I help set policy, all of the heavy lifting is done by Ajit and his crew. Sure, they were already generating $24 billion of float along with hundreds of millions of underwriting profit annually. But how busy can that keep a 31-person group? Charlie and I decided it was high time for them to start doing a full day’s work.
Again, that’s the type of stuff you wont read in any other shareholder statement. It makes the letter interesting, and everyone should read it in its’ entirety. These are just snips that I think are pertinent to the stuff I’m interested in – along with my comments that you can’t find anywhere else.
gk
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