Accounting, Corporate Finance, & Investing
Accounting, Corporate Finance, and Investing
What adjustments to reported earnings do you make?
[When goodwill was required to be amortized,] we ignored amortization of goodwill and told our owners to ignore it, even though it was in GAAP [Generally Accepted Accounting Principles]. We felt that it was arbitrary.
We thought crazy pension assumptions caused people to record phantom earnings. So, we're willing to tell you when we think there's data that is more useful than GAAP earnings.
Not thinking of depreciation as an expense is crazy. I can think of a few businesses where one could ignore depreciation charges, but not many. Even with our gas pipelines, depreciation is real -- you have to maintain them and eventually they become worthless (though this may be 100 years).
It [depreciation] is reverse float -- you lay out money before you get cash. Any management that doesn't regards depreciation as an expense is living in a dream world, but they're encouraged to do so by bankers. Many times, this comes close to a flim flam game.
People want to send me books with EBITDA and I say fine, as long as you pay cap ex. There are very few businesses that can spend a lot less than depreciation and maintain the health of the business.
This is nonsense. It couldn't be worse. But a whole generation of investors have been taught this. It's not a non-cash expense -- it's a cash expense but you spend it first. It's a delayed recording of a cash expense.
We at Berkshire are going to spend more this year on cap ex than we depreciate.
[Charlie Munger: I think that, every time you saw the word EBITDA [earnings], you should substitute the word "bullshit" earnings.]
Recommendation of a book on accounting?
I haven't read an accounting book in years. I think I read Finney[?] in college. I'd suggest reading Berkshire reports and things like magazine articles about accounting scandals. You need to know how figures are put together, but also have to bring something else. Read a lot of business articles and annual reports. If I don't understand it [an annual report], it's probably because the management doesn't want me to understand it. And if that's the case, usually there's something wrong.
[Charlie Munger: Asking Warren what good books he knows about accounting is like asking him what good books he has on breathing. You start with basic rules of bookkeeping, and then you have to spend a lot of time [to really become knowledgeable]].
What can be done to improve the accuracy of financial statements of financial institutions? What can be done to improve the integrity of financial statements?
Warren Buffett: It is a very tough thing. I still lean strongly towards fair value accounting—it is hard to use, but should we use cost? I think there are more troubles when you start openly valuing things at prices that don’t matter instead of best estimates, even if inaccurate. I would stick with financials reporting assets at fair value. When you get into CDO-squared [Collateralized Debt Obligation-Squared], the documentation is enormous. If you read a standard residential security prospectus it consists of thousands of mortgages, then different tranches. Then, you take a CDO and you take junior tranches on a whole bunch of juniors— put them together, and diversified in theory—a big error to start with. That was nuttiness squared. You had to read 15,000 pages to understand a CDO and 750,000 pages to evaluate one single security in a CDO-squared. To let people use the 100 cents they paid as the stated value versus the 10 cents it trades at in the market is an abomination. Fair value discipline, mild as it may be, may keep managements from doing some stupid things. I lean toward the market value approach. When you get towards complex instruments, I don’t know how you value it. Charlie, back at Salomon, I think you found one mismarked by $20 million, right?
Charlie Munger: A lot goes on in the bowels of American industry which is not pretty. A lot of people got overdosed on Ayn Rand. They would hold that even an axe murderer in a free market is a wise development. I think Alan Greenspan did a good job on average, but he overdosed on Ayn Rand, in that whatever happens in a free market is going to be all right. We should prohibit some things. If we had banned the phrase, “this is a financial innovation which will diversify risk,” we would have been far better off.
Would you comment on companies you say use questionable accounting practices to make their operations look good?
We follow a policy of “criticize by practice, and praise by name.” You could say we hate the sin, but love the sinner. So I can’t really name names of companies that I think are doing this kind of thing; I’ve found that if you go around criticizing others, pretty soon the criticism comes back on you.
[Charlie Munger: I don’t think they want names - I think she’s asking about the practice in general.
That’s different, then. The practices relate to accounting charges, done to smooth out earnings and make future earnings look good. It has become totally fashionable among managements to play with the timing of expenses.
Options expense recording has become optional as well; I haven’t seen tons of firms jumping on the chance to record stock compensation expense. And I think it’s deceptive to see it presented in the footnotes, the way it’s reported, because of the assumptions companies are using in valuing the options.
The thinking of these executives goes like this: “ Why should I penalize my shareholders for not doing something that others will do to help theirs?” And the bad practices become the norm.
[Charlie Munger: I certainly hope that we're better underwriters than Munich Re.]
Let's not name names. Munich Re is a fine company. Our policy is that we compliment by name and criticize anonymously. They [Munich Re] lost their AAA because they were too exposed on the asset side -- they would tell you this. They have an important position and we do a lot of business with them.
Some reinsurers we won't do business with. If there were a major financial or natural catastrophe, there are a number of reinsurers who wouldn't pay.
What does it mean to own stock in a company?
Owning stock in a company means that you own a piece of that company. If you own stock in the McDonald's company for example, it means you are one of the owners of McDonald's. Each piece of stock is called a share, and the more shares you own, the more of the company belongs to you. When the company is successful, your stock will become more valuable, too.
Where can you buy stock with the cheapest commissions?
There are many places to buy stocks, and the commissions all vary. It is important in life to look not for what is cheapest, but where the most value is delivered. I suggest that you ask your parents if they can check some of them out with you. Maybe you can make a chart where you can compare the costs on one side, with the services offered on the other. It will be a good exercise, and whether you buy stocks or not, you will learn from the process.
How do you know when you are going to lose money and when you aren't? Since the stock market changes every minute.
That is a very good question. The answer is you don’t know when you are going to make money or lose money. You are right, the stock market changes every minute. Because of that, you should never buy a stock expecting to make money in the short term. When you buy a stock, you are actually buying a share of that company. If it is a good company then you will make money over time as its value goes up. When you buy a stock, you need to imagine that the stock market will be closed for 20 years and you will not be able to look at its price. That way, you wont be distracted by the short term ups and downs. A company will be successful if it offers good products and services at a fair price while being run by honest, capable managers. Over the long run, such companies tend to appreciate and go up in value.
What's the role of the board of directors?
Most writers and shareholders probably have a little bit of a distorted view of how most large corporations have operated over the years. For a long time, most directors were sort of like potted plants. Management had its agenda and didn’t want input on major matters and Charlie and I can testify that we’ve had very little success in influencing big issues. If someone’s spent 20-30 years rising to become CEO, they don’t want a board telling them what to do. It’s changed a little bit today in terms of process.
Overwhelmingly, the most important job of the board is to pick the right CEO. If you were on the board of Cap Cities and you hired Tom Murphy, case closed.
The second most important job of a board is to prevent the CEO from overreaching. A board should bring independent judgment on acquisitions. There’s a natural tendency for CEOs to want to become bigger by spending other people’s money. The deal is already done by the time the board knows about it. The investment banker comes in and I’ve never seen a banker say, “This is a dumb idea.”
When a significant deal comes along, it’s a chance for the board to weigh in and discuss the economics of what’s going on. But the CEO doesn’t bring a deal unless he wants it done and so he stacks the deck.
Munger: I think big deals, on average in America, are contrary to shareholders’ interest.
Buffett: In most stock deals, the CEO thinks about what he’s getting, but not what he’s giving. You have to make sure you think about this. I can’t ever think of a discussion [when I was on a board] of weighing what you’re giving away vs. what you’re getting in a stock deal. If more value is being given away, then don’t do it! When I gave away 2% of Berkshire to buy Dexter shoes, it was one of the dumbest things ever. Not 2% of Berkshire then, but 2% of Berkshire today!
Munger: Fortunately, you’ve made some good decisions.
Buffett: Or half of you wouldn’t be here. It gets swept under the rug.
We owned a bank that went to acquire a smaller bank. The CEO of the smaller bank held out for a high price and various terms and conditions and, because he was taking stock, had one last condition for the acquiring bank: “Promise never to do a deal this dumb in the future.” [Laughter]
I’ve been on some terrific boards. The best was probably a local business, Data Documents. Every board member had a significant percentage of his net worth in the company and every decision was made for business reasons.
In contrast, the standard now is when deal is possible, trot in the investment bankers. I know the answer: they always say, “This is a great deal.”
At Berkshire, almost everyone on the board has a lot of Berkshire stock. They’re in the same position as shareholders. They don’t have D&O [Directors and Officers] insurance and they bought the stock in the open market. It’s a real owners board.
Your thoughts on EBITDA?
It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it.
We won't buy into companies where someone's talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don't, I suspect you'll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE and Microsoft -- they'll never use EBITDA in their annual report.
People who use EBITDA are either trying to con you or they're conning themselves. Telecoms, for example, spend every dime that's coming in. Interest and taxes are real costs."
Opinion on share buybacks? and dividends?
The equation is simple, but practice doesn’t always follow logic. Assuming you’ve been honest with shareholders [in communicating enough information so they can estimate intrinsic value], then if your stock is far below intrinsic value, buying it back adds a lot of value. The Washington Post did this and Teledyne bought back 90% of its stock over time.
Today, stock buybacks are popular. The underlying rationale – not the professed rationale – is that people hope the stock price won’t go down. But often this doesn’t make sense for shareholders. If the stock is underpriced, buy it back with excess cash; if it’s overvalued, don’t buy a single share.
If we wanted to return cash to shareholders, we’d go to them and say, “Our stock is cheap and we’re going to return cash to you by buying it back.”
In terms of dividends, you get into an expectational problem. Most public companies don’t bounce around their dividend from year to year (although this is very common in private companies and Berkshire subsidiaries) because investors come to rely on it. So once you establish a dividend policy at a public company, think a long time before changing it.
[Charlie Munger: The total amount paid out in dividends is roughly equal to the amount lost in trading and investment advice, so net dividends to shareholders are zero. This is a very peculiar way to run a republic.]
In a Fortune article I published in 1999 [Mr. Buffett on the Stock Market, 11/99], the frictional costs are equal to the total amount paid out in dividends.
Companies should be paying out dividends. Take See’s Candies: we haven’t figured out a way to grow it, so we can’t reinvest, so something approaching a 100% payout [of profits] would make sense [were it a public company]. Most managements want to ensure regularity [of dividends], so they go with a conservative level [below 100%].
We think about this at Berkshire. If we didn’t think we could put it [all of our excess cash] to work, then we’d pay it out. But we expect – and this is reasonable, I think – that we will have the chance to put it to work.
[If we decided to return cash to shareholders and] if our stock wasn’t underpriced, then we’d probably pay out a dividend – but don’t count on it anytime soon.
One reason not to pay a dividend is taxes, but we’ve always said that even if we could have paid a tax-free dividend, we would not have done so. Our test has been whether, if we retain a dollar, will it be worth more than a dollar in present value. So far we’ve always passed this test.
But it’s no fun sitting on $40 billion, which earned less than 1% last year after tax. The burden of proof will shift in the next few years. We always ask, “Can we use the money effectively within our business?” So far, the answer has been yes. This will be discussed at our board meeting on Monday.
Most of the time, we wouldn’t be able to buy an amount of our stock that would be material to our remaining shareholders. We probably have less opportunity to do so than other large companies.
[Buffett then put up this chart, which showed share turnover last year for the following companies: Berkshire Hathaway 14%, Exxon Mobil 76%, General Electric 48%, General Motors 487%, Wal-Mart 79%]
Look at these turnover figures. I think Berkshire has lower turnover by some margin than any major company in the U.S. I put Wal-Mart up there because the Walton family owns more of Wal-Mart than I do of Berkshire, so [our low share turnover is] not just because of that.
Our shareholders are long-term and loyal owners. We have the most honest-to-god attitude of ownership of any public company. People buy it to own it. It does mean that if it gets cheap, we won’t be able to buy much. But that’s OK. We’re not looking to make money off shareholders by buying them out at a discount.
The motivation for buying back stock used to be just because companies thought their shares were cheap. Thirty or forty years ago, it was very fertile to invest in companies that were buying back their stock. The most extreme case was Teledyne – we made some money investing there.
But that’s being swamped today by companies doing it because it’s in fashion or to prop up the stock. The SEC has rules to prevent propping up the stock on a daily basis [but companies still try to do it]. We wouldn’t do it for those reasons.
A few years ago, when we were willing to buy back our stock, the fact of writing about it [in the 1999 annual letter, page 16] eliminated the opportunity.
[It’s very interesting that Buffett had this slide prepared in advance. I think it’s because he knows his stock is cheap – we think it’s as cheap as it was on March 10, 2000, the only time he’s ever been willing to buy it back – and the company is much stronger and has a much brighter outlook than it did then. Buffett no doubt expected that he might catch some flak from shareholders for not announcing a buyback, but rather than addressing that question directly, he chose to deflect it by basically arguing that even if that would be the best use of Berkshire’s capital right now, the stock is too illiquid to buy back much stock anyway.
All of this being said, even if the stock were more liquid, I’m not pounding the table for share repurchases in light of the acquisition of Iscar. I’m drooling at the prospect of more acquisitions like this one – as are, I’m sure, Buffett and Munger.]
[Q - You've previously encouraged companies to repurchase stock. Please could you address the issue of Berkshire buying back its own shares?]
Buffett: My comments go back a lot of years. I haven’t written about other companies repurchasing in about 10 years. Repurchases in recent years were foolish, because they paid too much. They were trying to give out buy recommendations that weren’t justified. In the 1970s and 1980s, we encouraged others to repurchase because [shares] were demonstrably cheaper than anything else. We only felt in 2000 that we wanted to do so, because Berkshire’s intrinsic value [didn’t match] its stock price. But it was self-defeating [the announcement of Buffett’s intention to repurchase sent Berkshire’s stock higher]. [Repurchases] should be quite compelling, and that doesn’t exist now. Ninety percent of repurchases in the last five years were at silly prices and not in the interest of shareholders. Managers did it because it was what everyone else was doing. It’s interesting how many companies bought at two times current prices that aren’t [buying] now.
Why do you not believe in dividends when Benjamin Graham believed in them?
Warren Buffett: I had to show a little individuality. [laughter] I do believe in dividends, including dividends at companies where we own stock. The test on dividends is, ‘can you create more than one dollar of value with the one you retain?’ It would be a mistake for See’s to retain money because they have no ability to use the cash they make to generate a high return internally. We hope to move the capital to a place where it will be worth $1.20. If we do that, taxable or not, they are better off if we retain money. But when the time comes that we don’t think we can use money effectively, we will pay it out. But because we have the ability to redistribute money in a tax-efficient way within the company, we have more reason to retain earnings in the company. We like companies where we have investments to pay to us the money they can’t use effectively.
Charlie Munger: Costco paid no dividend when they were growing rapidly. As St. Augustine said: “God give me chastity, but not yet.”
[Q - From 2003 through 2008, Berkshire’s market price didn’t increase by the amount of retained earnings, why don't you change Berkshire’s dividend policy?]
Buffett: If we had to sell our business on December 31, 2008, we would have had a loss. Reinvested earnings did not produce [gains]. We use book value as a proxy for business value. We measure against the S&P 500—our intrinsic value has never had a five-year period when we underperformed the S&P 500.
Munger: I don’t get too excited about these oddball things that come along once in 50 years. I think Wells Fargo [for example] will come out of this mess much stronger.
Buffett: In a terrified market, Wells Fargo got to below $9—when aspects of their business were never better, and their business model is fabulous. Pushed by a student, I said that if I had to put all of my money in one stock, it would be Wells Fargo at $9.00. Wells will be a lot better off a couple of years from now than if all this business had never happened, unless they have to issue lots of shares, which they shouldn’t. You never want to be in a position to have to sell [due to a margin call] or emotionally. Why would someone sell Wells Fargo at $9.00 when they bought it at $25.00, and now it’s better off? It’s crazy. I own a farm about 30 minutes from here, and if you own a farm, you don’t get a price on it every day. Look at the asset for value, not the price—as you would with a farm. People let the stock price, not business results, [affect their assessment of a company]. Read Chapter 8 of The Intelligent Investor. The fact that a [price] quote is available every day turns into a liability.
Your thoughts on inflation?
The best thing to combat the threat of inflation is to have a lot of earnings power of your own. If you’re the only surgeon in town, you’ll be OK [because you can simply raise your prices to keep up with inflation and people will pay it]. Charlie and I think it’s best to own fine businesses that can price in inflationary terms and don’t require big capital investments. See’s Candies can handle an inflationary world and maintain value.
Unfortunately, most businesses will not come out well in real terms. Earnings might be up, but the business will be compelled to invest more and more dollars into the business to stay in place. The worst businesses compel you to put more and more in, without any rise in profits.
TIPS [Treasury Inflation Protected Securities] are not a bad investment for people worried about inflation heating up, which we’re seeing signs of.
[Charlie Munger: Most people will see declining returns [due to inflation]. One of the great defenses if you’re worried about inflation is not to have a lot of silly needs in your life – if you don’t need a lot of material goods.]
Buffett: Charlie, we’re selling a lot of material goods in the other room, so keep quiet. [Laughter.]
The talk of deflation was total nonsense.
You would think that the trade deficit, which has resulted in a weaker currency, would have led to higher inflation.
The price of oil has risen far more in dollars than in euros.
So, inflation matters. It’s always there and is something we think about. But See’s Candies will do fine in an inflationary environment.
[Charlie Munger: So far, the weak dollar has acted to restrain inflation.]
Yes. For example, we’re paying less for shoes, few of which are made in the U.S. anymore.
We don’t want to be long the long bond [e.g., he thinks there’s risk of rising interest rates].
But if you’d told me two years ago what the macro conditions would be today, I’d have been very surprised by where interest rates are today [i.e., he thought they’d be higher].
[Charlie Munger: There won’t be an automatic correlation between interest rates and inflation – there will be weird things.]
[Q - An 11-year-old from New Jersey asked how inflation will affect his generation. How is Buffett preparing for inflation?]
Buffett: Inflation is going to affect you. Long term, even a small amount is bad. It’s certain we’ll have inflation over time. Volcker opined against an FOMC [Federal Open Market Committee] 2% target for inflation. It is something of a slippery slope. Current policies are bound to have inflationary consequences. Inflation is a classic way to reduce the cost of external debt. Federal revenues are going down. Politicians say that taxpayers pay for this or that, but if taxes are less now, who’s paying? The real payers are [those affected by] the shrinkage of the value of the dollar down the road. The people who are really paying are those that are buying fixed income investments now—the Chinese, for example. That’s the ultimate price of stimulus. The easiest thing to do [inflate] is the likeliest. The best protection from inflation is your own earning power. The second best is owning a wonderful business, such as Coke, that doesn’t require capital. With Coke, you’ll get your share of national earnings.
Munger: The young man should become a brain surgeon and buy Coke stock, not [government] bonds.
Buffett: I get paid by the word. He doesn’t. [laughter]
[PIMCO’s] Bill Gross has written about whether inflation is being captured correctly. If you go out to the Nebraska Furniture Mart, you’ll see that prices haven’t moved up much over time. And in some areas, like DVD players, prices are down 75%, so there’s been deflation.
But when I see that “core” inflation excludes food and energy, I can’t think of anything more core than food and energy. Also, the CPI [consumer price index, the official measure of inflation] uses a computed rental price, but this does not reflect new housing prices. The rental factor has significantly lagged the rise in housing.
But if you own your own house and drink Coke, you’re less affected – my CPI, for example, hasn’t changed very much. But if you’re buying a house and drive 40 miles to work every day, your CPI has gone up a lot.
Munger: I see almost no change in the price of the composite product that flows through Costco [Munger is a Director of Costco]. I don’t feel sorry for the people who pay $27 million for an 8,000-square-foot condo in Manhattan. So inflation comes in places.
Buffett: Costco’s and Wal-Mart’s LIFO adjustments are almost nothing – it’s inconsequential. [LIFO stands for “last-in, first-out”, and means that when a product is sold from inventory, its cost is based on the price paid for the latest such items purchased by the company. If the cost of the product is rising rapidly, this can cause the old inventory to become valued at less than the current market cost, necessitating a LIFO adjustment. In contrast, if there’s no inflation, the LIFO adjustment is nil.] You’re dealing with $200 some billion in sales at Wal-Mart and the LIFO adjustment would pick up any inflation [but it’s not there].
In our jewellery stores, there have been big LIFO adjustments recently. It’s the same with our steel operations. Carpet prices went nowhere for 20 years, but because it’s petroleum based, it’s moved up a lot recently and now we have $100 million or so in LIFO adjustments.
Overall, for a typical young family, the CPI probably understates inflation in terms of their living situation.
[Q - Inflation problem you talked about in 2008 letter, but you didn’t mention inflation in 2009 letter. Why?]
Warren Buffett: I may be biased, as I have always worried about inflation. And there has been a lot of inflation. I was born in 1930 and the dollar is down 90% since then but we’ve done okay. I think prospects for inflation around world have increased. Situations that governments have been forced into or allowed to embrace may cause it. Weaning ourselves from medicine may be harder than original illness, there is massive debt. I don’t see any way countries running high debt to GDP over time doesn’t have diminution of currency over time. I wrote OpEd in NYT last year. I would bet on higher inflation, and maybe a lot higher.
Charlie Munger: Again, I agree.
[Q - What are key metrics you look for on inflation, and catalysts for a future rise?]
Warren Buffett: You give me credit for more brainpower than I actually bring to the question. You can’t look at any metric. If it gets going, it creates its own dynamic and is very hard to stop. We saw it in 1970s until Volcker came in with a sledge hammer. Prime rate was at 21% and governments up to 15%. We had a demonstration project 30 yrs ago. If we continue today’s policies, something like that could be possible. Trend is not destiny. We have power to control our future. We do it through elected representatives If inflation gets into saddle, faith in institutions could break down.
Currencies are a poorer bet than they have been in a long time but I do not know what that means for the near future. Remember that your money can be inflated away but your talent cannot. As long as you are the best at what you do you will be entitled to your portion of profits.
Charlie Munger: Contribute the most to civilization and counter the effects of inflation. To outsmart others isn’t the best way to do it. If you are best painter or best brain surgeon, you will always command your share of the economy around you. Talent is terrific asset to deal with it. The best defense is to contribute to the world and to try to make yourself more talented.
Do you see deflation as a threat to our investments?
I have a tough time envisioning a world in which we have to worry about deflation - but I don’t have much of a record on that, being a macro kind of issue. Deflation, if you think about it, helps investors and savers, because it raises the value of your cash.
Truth is, I don’t know how it would affect us.
What's your opinion of Enron and creative accounting?
[Charlie Munger: "Creative accounting is an absolute curse to a civilization. One could argue that double-entry bookkeeping was one of history's great advances. Using accounting for fraud and folly is a disgrace. In a democracy, it often takes a scandal to trigger reform. Enron was the most obvious example of a business culture gone wrong in a long, long time.]
To the extent people will look more carefully at companies, Enron was a plus to the American economy.Enron will have a distinct beneficial effect on auditors, and it was much needed.
[Charlie Munger: "It will have a distinct beneficial effect on one less auditor.
I think it would have been a shame if Salomon had gone under. Charlie and I may disagree on this one. What about the innocent bottom 40,000 people at Arthur Andersen?
[Charlie Munger: "I regard it as very unfair, but capitalism without failure is like religion without hell. When it gets this bad and there's a lack of system for control -- which Arthur Andersen didn't have -- maybe a firm should just go down."]
What if we did something terrible? Would it be fair for all of Berkshire's employees to suffer?
[Charlie Munger: "We couldn't do anything that would bring down Berkshire…Arthur Andersen was particularly vulnerable because it was a partnership. A partnership must be extra careful in its behavior, choosing clients, etc."]
Gen Re was discounting Workman's Comp reserves at 4.5% -- figures we inherited. These were not conservative, so we're now using 1% in 2003 and going forward. Thus, our figures [reported profits in Q1] would be even better if we hadn't made this change.
[Charlie Munger: This accounting change is typical of Berkshire. We're so horrified by aggressive accounting [that is rampant in Corporate America] that we reach for ways to be conservative. It helps our business decisions and protects Berkshire. How did we get in situation where we're all so close to the line?]
I felt much more comfort working with financial statements in the 1960s than today. There was more information then, even through there was less disclosure.
In the case of Gen Re, [having overly aggressive] Workman's Comp reserves was a quick fix, but it's like heroin. Like trade loading, people seek a quick fix. People are encouraged by their CFO or auditors to play with their numbers. It never works, though I guess if you're 64 and a half [years old and about to cash in your stock and retire], maybe it does. It's so much better to address problems.
[In a news conference on Sunday, Buffett was quoted as saying: "You would be amazed how compliant auditors have been in the past decade, not only co-operating but suggesting techniques for making numbers less useful -- less truthful -- to investors."]
The real problem is [accounting for] pension and healthcare liabilities. I've looked at companies recording pension income of hundreds of millions [of dollars] when their pension plan is underfunded by billions [of dollars]. It's the same mentality as stock options.
Any accounting that gives people a rationale to reduce reserves even further is bad. There’s such a tendency to reduce reserves for long-tailed [insurance] policies – to understate them – especially if the CEO is retiring or options are vesting.
In derivatives, both sides book a profit; this is especially true of traders who are on commission.
We’re three years into unwinding Gen Re’s derivatives book and you would not believe the complexity. Most of it was marked to market, so you’d think it would only take a few days to unwind.
I don’t think any regulator or auditor [has any hope of getting a handle on any big derivatives book].
[Charlie Munger: The stupid and dishonest accountants allowed the genie of totally inappropriate accounting to descend on derivatives books. And once this has happened – people get status, etc. – it’s impossible to get it back into the bottle.
The housewife preparing her toast in the morning just isn’t worried about a derivatives blowup.
The people with vested interests in the status quo are very powerful. If you’re going to try to fix this, you’re going to have a very interesting life.]
What's your opinion of day trading?
Buffett: If you take the percentage of bonds and stocks held by people who could change their minds tomorrow based on what the Fed does, etc., it’s gone up a lot. I call it an electronic herd, who change what they do every day or minute. The turnover of stocks has gone from 40% to over 100%, and the turnover of bonds has gone up dramatically as well. There’s nothing evil about it, but it’s a different game and there are consequences. If you’re trying to beat the other fellow on a day-to-day basis and you’re watching the news or the other fellow, and you think he’s going to push the sell button, you’ll try to push it quicker.
When Charlie and I were at Salomon, they talked about 5- or 6-sigma events, but that doesn’t mean anything when you’re talking about real markets and human behavior. Look at what happened in 1998 and in 2002. You’ll see it when people try to beat the markets day by day.
When I set up my partnership [the Buffett Partnership], I told my partners they’d hear from me once a year.
Munger: When people talk about sigmas in terms of disaster probabilities in markets, they’re crazy. They think probabilities in markets are Gaussian distributions, because it’s easy to compute and teach, but if you think Gaussian distributions apply to markets, then you must believe in the tooth fairy. It reminds me of when I asked a doctor at a medical school why he was still teaching an outdated procedure and he replied, “It’s easier to teach.” [Laughter]
Buffett: It’s very disturbing to spend years learning higher mathematics and then learn that that stuff has no utility or that there’s even counter-utility. It’s hard to change, so people just keep on teaching [incorrect things].
What's your opinion on asbestos liability?
Asbestos is a big part of our liabilities. But we are capped, which is a good thing because asbestos continues to explode. Last year, we said it would be worse than anyone expected and it has been and will continue to be. Many companies thought to be insulated are being dragged in.
Asbestos is actually creating some opportunities for Berkshire to buy companies that went bankrupt due to asbestos claims -- free of asbestos liabilities. We probably wouldn't own Johns Manville were it not for asbestos.
It's a cancer on the American corporate world and it's growing.
[Charlie Munger: "Asbestos has morphed into a situation with enormous amounts of fraud, etc. People with serious injuries are being hurt [as more and more money flows to the plaintiff's bar and claimants with no current injuries]. The Supreme Court has practically invited Congress to step in, but Congress has refused due to the influence of the trial lawyers. I'd be surprised if there's a constructive solution in the next five years. I expect there will just be more of the current mess.
There was a solution, but the Supreme Court didn't allow it.
We've very careful to avoid asbestos liabilities. I'm not worried about our insurance companies [via-a-vis their exposure to asbestos].
You have a plaintiff's bar -- going beyond asbestos -- that will take any human adversity and try to make a profit out of it by suing those with deep pockets.
[Charlie Munger: What’s happened in asbestos is that a given group of people get mesothelioma – a horrible cancer that comes only from asbestos exposure and kills people. Then, there’s another group of claimants who smoked two pack of cigarettes a day and have a spot on their lung. Then you get a lawyer who gets a doctor to testify that every spot is caused by asbestos. Once you effectively bribe a doctor, then you can get millions of people to sue on fears of getting cancer.
But there’s not enough money [to pay all of the claimants], so people who are truly harmed don’t get enough. In a southern state with a jury pool that hates all big companies [you get big judgments], but lawyers are stealing money from people who are hurt and giving it to people who aren’t entitled. It’s a bonkers system, but with federalism [state’s rights], there’s no way to stop it. The Supreme Court refused to step in.
The Manville [Personal Injury Settlement] Trust [created when Johns Manville went into bankruptcy; it separated the operating company from the asbestos liabilities; Berkshire bought the operating company and the proceeds went into the trust to pay asbestos claims] had more new claims last year than in any year – and the company last mined and sold asbestos 35 years ago.
Trying to buy people off is like trying to put out a fire by dousing it with gasoline. With word processors, lawyers can easily produce countless claimants. But only 25% of the money goes to claimants – the rest goes to the lawyers, doctors, etc.
The only people who can fix it are the Supreme Court or Congress. The Supreme Court – some people would say rightly – refused to get involved [but I say] they chickened out. And Congress, given the politics, has yet to step in.
There’s an important lesson here: Once wrong-doers get rich, they get enormous political power and you can’t stop it, so the key is to nip things like this in the bud.
It would be easy to fix the problem: the right way is to say we’re not going to pay off all these little claims.]
We own Johns Manville and their behavior was reprehensible.
[Charlie Munger: Johns Manville’s behavior was one of the worst in the history of Corporate America – they knew asbestos hurt people and covered it up to make more money.]
We have no connection to this. The Manville Trust has billions of dollars and has been around for close to 20 years.
It didn’t have a record number of claims last year due to new injuries. Rather, it’s a honey pot. But they’re only paying 5% on claims, so the guy who’s been drastically injured is only getting a small amount. It’s not the right way to do it.
Regarding the proposed legislation [in Congress]: in the end, we didn’t support it. It wasn’t the answer we needed.
The Supreme Court, when they ducked it, they left a problem that will be around for decades and decades.
[Charlie Munger: If you want to be cynical, look at the perjury. There are only three solvent companies left [facing asbestos claims], so [surprise!] plaintiffs can only remember those three names [when recalling which products they were exposed to decades ago]. It’s a case of perjury being suborned by practicing lawyers.]
[Charlie Munger: There’s been terrible behavior by doctors, terrible behavior by lawyers, gutless behavior by courts, and even more gutless behavior by politicians, who [he said something disparaging about them].
You keep hoping that it will get so bad that things will change, that reform will happen. And it can happen: for example, the Workman’s Comp system in California. With the Schwarzenegger revolution in California, it’s been partly – maybe 15% – corrected. If it gets bad enough, it’s possible that it could be fixed.
It’s crazy that judges give money to people who smoked two packs of cigarettes a day for their entire lives, are dying, and have one little spot on their lungs.
Even asbestos will eventually go away, but who knows how much damage will be done before the storm passes.
But the behavior is so terrible It’s that kind of behavior that makes me talk about [the U.S. being at] the apex of its civilization.]
What are your thoughts on short selling?
It's an interesting item to study. It's ruined a lot of people. You can go broke doing it.
You'll see way more stocks that are dramatically overvalued than dramatically undervalued. It's common for promoters to cause a stock to become valued at 5-10 times its true value, but rare to find a stock trading at 10-20% of its true value. So you might think short selling is easy, but it's not. Often stocks are overvalued because there is a promoter or a crook behind it. They can often bootstrap into value by using the shares of their overvalued stock. For example, it it's worth $10 and is trading at $100, they might be able to build value to $50. Then, Wall Street says, "Hey! Look at all that value creation!" and the game goes on. [As a short seller,] you could run out of money before the promoter runs out of ideas."
Everything we've ever thought about shorting worked out eventually, but it's very painful. It's a whole lot easier to make money on the long side. You can't make big money shorting because the risk of big losses means you can't make big bets.
[Munger: "Being short and seeing a promoter take the stock up is very irritating. It's not worth it to have that much irritation in your life."]
We would never short anyway because we're too big.
[Charlie Munger: "It's dangerous to short stocks."]
"Charlie and I have agreed on around 100 stocks over the years that we thought were shorts or promotions. Had we acted on them, we might have lost all of our money, every though we were right just about every time. A bubble plays on human nature. Nobody knows when it's going to pop, or how high it will go before it pops.
A.W. Jones, which had a long-short model, developed the best-known hedge fund in the late 1950s and early 1960s. They were market neutral, but didn't stick with it. Something went wrong with A.W. Jones. A very high percentage of its spin-off funds bit the dust. There were suicides and people lost their fortunes and had to drive cabs.
Ben Graham didn't find shorting particularly successful. Quite a high percentage of his paired investments worked, but he lost a lot on the few he lost on.
I had a harrowing experience shorting a stock in 1954. I wouldn't have been wrong over 10 years, but I was very wrong after 10 weeks, which was the relevant period. My net worth was evaporating.
Shorting is just tough. You must bet small. You can't short the whole company. It takes just one to kill you. As it rises, it consumes more and more money.
There’s nothing evil about short selling. There are people on the short side who have done things to make some stocks go down – some of which is appropriate and some of which is inappropriate. People do that on the long side as well, so I have no ax to grind with short sellers. We have no problem with anyone shorting Berkshire stock. There’s nothing I’d like more than to be paid to lend my stock to shorts.
I do think it’s a very tough way to make a living, both financially and psychologically. If you buy something at $20, you can lose $20. If you short at $20, you’re loss can be infinite.
As you know, we have a friend who’s been outspoken on naked shorting [referring to Overstock CEO Patrick Byrne, who used to be President and CEO of Berkshire subsidiary Fechheimer Brothers]. I don’t have a great problem with it. If anyone wants to do that with Berkshire, more power to ‘em.
Companies with a large short interest very often have been revealed as frauds or semi- frauds – not the one my friend runs. Over the years, I’ve probably had 100 ideas of things to short and I would have eventually been right [on almost all of them]. But [because it’s so hard to get the timing right,] I likely wouldn’t have made much money and there would have been a huge opportunity cost. Someone who’s running a fraud is probably very good at it and can keep it going a long time. I would never put money with a short fund – not because I have any problem with it ethically, but because I question if they could make money over time.
[Charlie Munger: It would be one of the most irritating experiences in the world to do a lot of work to uncover a fraud and then watch it go from X to 3X and watch the crooks happily partying with your money while you’re meeting margin calls. Why would you want to go within hailing distance of that? [Laughter]]
I’ve never been in a position to ask a broker from whom I’ve bought to deliver the shares and not had it happen.
I don’t see the problem of people shorting stocks, assuming they’re not manipulating the market. I would welcome people wanting to short Berkshire. In fact, I’d lend them stock and earn extra income. They’re a certain future buyer.
If anyone wants to naked short Berkshire, they can do it until the cows come home. In fact, we’ll hold a special meeting for them. [Laughter]
The shorts generally have a tougher time of it in this world. More people are bullish on stocks. It’s a tough way to make a living. It’s very easy to spot a phony stock or a heavily promoted stock, but it’s hard to say when it will turn. If it’s trading at five times its intrinsic value, there’s no reason it can’t trade at ten times.
I don’t see shorts as any great threat to the world. If a lot of people want to short your stock, they have to pay you [for the borrow]. We did this with USG. One large brokerage firm approached us [about lending out our stock] and we were happy to do this. We charged them a lot. We even forced them to hold it for a certain period of time so we could continue to earn money on the borrow.
Munger: There’s tremendous slop in the clearance process. It’s not good for a civilization. It’s like having slop in the management of your nuclear power plants.
Buffett: If I buy 1,000 shares of GM and ask my broker to deliver it and he doesn’t, what’s the situation?
Munger: If you’re a private customer, you have to wait a while. There’s a lot of slop in derivative trading.
Buffett: But can’t I take my broker to court after three weeks?
Munger: I don’t think that there’s any court that can give you a stock certificate just because you want it.
[Q - What do you think of short sellers being investigated for being publicly bearish and short selling companies? Is short selling healthy? Is a healthy discussion between bulls and bears healthy for the markets?]
Buffett: There is nothing wrong with people who are positive or negative speaking out as long as they are responsible for what they say. You can do things on the long or short side that are unethical or illegal. Anytime you attack conventional wisdom though, you will get a lot of negative feedback. When he and Charlie criticized the EMH (Efficient Market Hypothesis), it was so widely accepted people didn’t like their comments. In general he has no problem with short selling.
Munger: For the most part we are criticizing the wrong people (the short sellers). The people the criticisms should go to are the accountants who allowed the bad accounting should be held in the dock. The accountants let this happen, and they get very little criticism, and that is a mistake.
Opinion on IPOs?
[Charlie Munger: It is entirely possible that you could use our mental models to find good IPOs to buy. There are countless IPOs every year, and I’m sure that there are a few cinches that you could jump on. But the average person is going to get creamed. So if you’re talented, good luck.
IPOs are too small for us, or too high tech, so we won’t understand them. So, if Warren’s looking at them, I don’t know about it.]
An IPO is like a negotiated transaction – the seller chooses when to come public – and it’s unlikely to be a time that’s favorable to you. So, by scanning 100 IPOs, you’re way less likely to find anything interesting than scanning an average group of 100 stocks.
The seller of a $100,000 house in Omaha will never sell for $50,000. But if 100 entities each owned 1% of a basket of homes in Omaha, the price could be anywhere.
You’re way more likely to get incredible prices in an auction market.
Are corporate jets a waste of shareholders’ money?
I want to report that we’re solidly in favor of private jets. [Laughter]
Charlie used to travel by bus, and only when they had a senior discount. In recent years, I’ve shamed him into getting a NetJets share; I have two. Berkshire is better off because we use corporate jets. I don’t know which deals wouldn’t have been made, but I do know [that without a private jet] I would not have had the enthusiasm to travel thousands of miles to see deal after deal. It’s a valuable business tool.
It can be misused like everything else. I remember that one time we invested in a company and the CEO stopped in Omaha to see me. He used a grocery chain in Idaho to test products, but also had a lodge there. Properly used, corporate jets have been a real asset to Berkshire.
Munger: If the trappings of power are greatly abused, I think you would find those companies would be disappointing to investors. The Roman emperor who was best remembered was Marcus Aurelius – he had no trappings of power, though he could have. The best way to combat [the excesses of leaders] is to have examples of exemplary behavior.
Can you forecast the continuing debate between Efficient Market Theory (EMT) proponents and value investors? Are your designated successors “outliers” as well?
The market is generally fairly efficient in evaluating asset classes, but not always efficient in valuing specific businesses. I think EMT probably hit its peak in popularity twenty years ago; it became terribly popular in academia. You had to buy into it to get anywhere in academia. People would have had to give up the work on their Ph.D. theses if they rejected the EMT.
It doesn't appear to be as popular these days. I don’t know if it’s as much holy writ as it once was. Some schools are now offering other courses that really help you learn to value a company. But it’s hard to dislodge a belief that becomes dogma in finance departments.
[Charlie Munger: The old guard of physicists also clung to their beliefs and wouldn’t accept the findings of the new crop of physicists. The old guard eventually died off, their teachings faded away, and the work of the new physicists became accepted. That will happen with the efficient market theorists, too.]
There’s something about the whole thing that’s always puzzled me. If companies are always valued perfectly because everyone else knows more than you do about everything, then there’s nothing else for you to do. I’ve always wondered what they talk about on the second day of class in that course. The first day they tell you that the markets are efficient and value everything just fine. So now what do we do?
How did you get to be so rich?
I was lucky to be born in a free country like America where I had all kinds of opportunities. And I had parents who made sure I understood the importance of a good education, and I learned at a very early age how important it is to work hard and be honest. I always had an interest in business, and learned how important it was to listen and learn. I only invest in a business I fully understand, and then I am patient and I let my investment grow. My advice to you is to work hard in school, and look for something you like to do. If you are happy, you will be successful.
What is your unified principle?
Warren Buffett: In ten words or less. [laughter]
Charlie Munger: Pragmatism. Partly we do it in our different ways because it suits us, and partly because it works better. It is just that simple. We’ve had enough good sense when something working well, keep doing it. The fundamental algorithm of life: repeat what works.
Thoughts on banks willingness to deal with shady characters?
Munger: It’s amazing what goes on. Salomon was at least as disciplined and rational as other investment banks, but by the end Salomon was begging for investment business from Robert Maxwell, whose nickname was “The Bouncing Czech.” You’d think if this was his nickname, investment banks wouldn’t be chasing his business.
The day they found him bobbing [in the water; he committed suicide as the scandal about his misdeeds broke], we [Salomon] sent money to him in exchange for money he was sending to us, but he didn’t pay. So, we went to England to collect from his sons and it was a mess. We got what we deserved.
To an investment banker, his earnings would be affected to a significant way if he wrote a few more tickets to Maxwell. You have to control this if guys can make money by bringing dubious things in the door.
[Buffett and Munger chuckled to themselves as they recalled Salomon doing business with another shady character they didn’t name. At the 2002 annual meeting, however, Munger identified the company as First Normandy, an IPO that Salomon had to pull before money exchanged hands when they discovered the promoter had completely manufactured his record. In fact, the company was called Normandy America Inc. and, according to a report on the SEC’s web site, “Normandy's stock commenced trading on the NASDAQ National Market System on August 15, 1995. One day later, Normandy withdrew its offering from the market and rescinded all trades.”]
[CM [dripping with sarcasm]: That was a wonderful experience. Warren, Lou Simpson and I were all on the board [of Salomon], we were the largest shareholders, and we said, “Don’t do business with this guy.” But they ignored us and said that the underwriting committee had approved it.]
He had a neon sign on him saying “CROOK.” He did go to jail. Incidentally, he claimed to have owned a lot of Berkshire stock and to have made a lot of money on it, but I checked the shareholder records and couldn’t see it. It could have been in street name, but for a block that big, I think I would have found it [so he was probably lying about his Berkshire holdings.
Risk of holding assets at banks or brokerage houses?
As a depositor in major banks and brokerages firms, I wouldn’t worry. We have a too-big-to-fail view toward large institutions to protect depositors – though this is not true of equity holders or margin accounts.
Any comments on the behaviour of accountants in tax avoidance schemes?
Some of the tax shelter proposals that were sponsored by the most prominent auditing firms were absolutely disgusting. [Such schemes are one of the] reasons why the middle class pays more taxes than it should.
Berkshire is a heavy contributor to the Treasury. As I pointed out in the annual report, if only 540 contributors paid what we did last year, no-one else would have pay anything – corporate, personal, social security, etc. taxes.
Sure, we buy tax-exempt bonds sometimes but we pay full 34% taxes on our capital gains.
[Charlie Munger: You’ll better understand the evil when top audit firms started selling fraudulent tax shelters when I tell you that one told me that they’re better [than the others] because they only sold [the schemes] to their top-20 clients, so no-one would notice.]
And the lawyers wrote the opinions [blessing these schemes] – don’t leave them out.
We had people come to our office, from top auditing firms – but not our auditors [Deloitte & Touche] – and they wanted us to sign confidentiality agreements for schemes to set up 20 offshore trusts, etc. It was designed to be so complex and spread out that no [IRS] agent could figure out the totality.
It makes everyone else pay more. I was a little hard on Pamela Olsen [Assistant Secretary for Tax Policy at the U.S. Treasury, who Buffett criticized in his annual letter (pages 6-7) for accusing him of “playing the tax code like a fiddle”], but I applaud Pamela on her work exposing this.
Does protection of the banking system warrant the lack of public disclosure in Bank of America’s purchase of Merrill Lynch?
Buffett: That’s a very tough question. It was a very fragile situation. If Bank of America backed out, it would have set things in motion. It [Merrill] could not stand on it own. The CEO was in a tough spot. Would I have behaved differently than Bernanke or Paulson? Ask Charlie what he would do. [laughter]
Munger: You can legitimately criticize Bank of America’s acquisition of Merrill Lynch. But once they signed the contract, I believe Bank of America and the Treasury acted honorably. Read the “history of the deal” [section] in the proxy statements. Bank of America got two fairness opinions in 24 hours at a cost of $20 MM. They needed a fairness opinion on the fairness opinions. [laughter]
Buffett: I’m sure they hope you’ll be on the jury. [laughter]
[Comment: The “history of the deal” sections of proxy statements can make for fascinating reading.]
What is the main contribution to the stock market crash of this century?
This is a very difficult question to answer and even the smartest and best economists don't have a clear answer or agreement. One thing that we do know is that when a stock price goes down, there is less demand than there is supply at that price. More people want to sell their shares of that company, than want to buy, so the price keeps getting lower until somebody is willing to buy it.
Are investment banks so complex that the head is not aware of the risks?
Warren Buffett: Exceptionally good question. The answer is probably yes in most places, though there are a few CEOs I respect a lot. Gen Re had 23,000 derivative contracts. I could have worked full time on that, and I probably still couldn’t have gotten my head around it all. And we had exposures that I thought were possible and heads of business units didn’t — I don’t want slim, I want none. I am Chief Risk Officer at Berkshire. If something goes wrong, I cannot assign it to a committee. I think big investment banks and big commercial banks are almost too big to manage effectively in the way they have elected to run their business. It will work most of the time. You may not see the risk. A 1-in-50-year risk - it won’t be in the interest of a 62 year old executive who is retiring at 65 to worry about it. I worry about everything. Many CEOs say they didn’t know about what was going on. It’s easier to admit he doesn’t know what’s going on than to admit that he knew what was going on and let it go on. I’ve been asked for advice on regulation. Somehow, the press hasn’t picked up on this too much. OFHEO [Office of Federal Housing Enterprise Oversight] supervised Fannie [Mae] and Freddie [Mac]—their activities had a public element, and were semi-regulated. For 200 people [at OFHEO] it was their sole job to examine the books. They were two-for-two with two of the biggest accounting scams in the history of the world. The person at the top must have it in their DNA to see risks. In many ways, there are firms that in terms of risk are too big to manage. If too big to fail, there are interesting policy implications.
Charlie Munger: It is crazy to allow things, which are run with knavery, to get too big to fail. As an industry, there is a crazy culture of greed and overreaching and overconfidence, trading algorithms. It is demented to allow derivative trading such that clearance risks are embedded in the system. Assets are all “good until reached for” on balance sheets. We had $400 million of that at General Re, “good until reached for”. In the drug business, you must prove it is good. It is a crazy culture, and to some extent, an evil culture. Accounting people really failed us. Accounting standards ought to be dealt with like engineering standards.
Warren Buffett: Salomon [Salomon Brothers during the 1991 scandal] was trading with Marc Rich who had fled the country. They said they wanted to keep trading with him. Only by total directive could we stop it. I think the Fed did the right thing with Bear [Stearns]. They would have failed on Sunday night, and walked to a bankruptcy judge. They had $14.5 trillion of derivative contracts — not as bad as it sounds, but the parties that had those contracts would have been required to undo the contracts to establish the liability from the estate. With the $400 million at Gen Re, we had 4-5 years. At Bear, it would have been 4-5 hours. It would have been a spectacle. Two of the witnesses at the testimony said, ‘we understood we couldn’t borrow unsecured, but we didn’t understand we couldn’t borrow secured.’ The world does not have to lend you money. If they don’t want to lend you money, an extra 10 basis points won’t make a difference. It depends on people’s willingness to lend you money, which comes down to how other people feel about you. If you are dependent on borrowed money, you have to wake up every day worried about what the world thinks of you.
What are the risks in the financial system? (2005)
I think our currency will weaken, but I’m not the Armageddon type. I think most of our citizens will be better off in 10 or 20 years.
I’m concerned about our political leadership, but as Peter Lynch once said, “Invest in businesses any idiot could run because someday one will.” (Laughter) We’ve had all sorts of bad Presidents, but have still done well. Our real GDP per capital rose seven-fold in the last century, which is remarkable.
Sure, the big consumer debt load and trade deficit could cause some financial market distress – there are great investment opportunities in dislocations – but the country will survive.
Eventually the country will do fine, but there’s a significant possibility of a chaotic situation.
[Charlie Munger: We don’t have any great record making macroeconomic predictions. It’s obvious that we could have some kind of convulsion however.]
Far greater sums in one asset class after another are on a hair trigger. We’re piling up huge financial assets at intermediaries, which lend themselves to huge dislocations. We’ve turned over huge amounts of money to people who want to beat the S&P in the short term, and while they may appear to be independent, their actions are not independent. They can all try to head to the exits at the same time. But if you’re selling, you must find a buyer. The only way to sell a burning seat in the theater is to find someone else to buy it.
[Charlie Munger: There’s way heavier leverage by hedge funds and [others] today.
I knew a guy who had $5 million and owned his house free and clear. But he wanted to make a bit more money to support his spending, so at the peak of the internet bubble he was selling puts on internet stocks. He lost all of his money and his house and now works in a restaurant.
It’s not a smart thing for the country to legalize gambling [in the stock market] and make it very accessible.]
Is there anyone we’ve forgotten to offend? We don’t want to miss anyone. (Laughter)
[Q - Risks in the Global Financial System?]
Charlie and I are not as on board on this, so I’ll answer it and then Charlie can share his thoughts.
We have a $618 billion trade deficit and an even larger current account deficit. As large as we are, something will change [for the worse] and the longer it goes on, the worse it will be. Most economists say a soft landing is likely, but they don’t say what this [will look like]. How the numbers come down is quite significant. Paul Volcker has expressed apprehension about [the likelihood of] a soft landing.
There’s as high a percentage as there’s ever been of money on a hair trigger – in foreign exchange, stocks, bonds, the carry trade... When people go to bed at night – an electronic herd – that can sell billions of dollars at the press of a key. I think this is at an all-time high. An exogenous event, like Long Term Capital Management – and it will happen – could trigger a stampede.
If you hold dollars, you can’t get rid of them. You can’t sell them to the U.S., because you’d get dollar-denominated assets in return. And you can’t sell them to another country, like France [I forget the reason he gave].
[He read a quote from Paul Volcker’s recent article in the Washington Post and concluded:] The situation is dangerous and intractable and is at an all-time high. But I can’t predict the timing.
I would say that what’s going on with the trade deficit will have serious consequences. But in the last Presidential race, neither candidate addressed it, which is understandable. 90% of the American people can’t define “current account” and it’s hard to describe in three minutes. And it’s not the kind of issue that Betty [the average American voter], when she’s making her toast in the morning, asks herself, “Gee, that trade deficit is really unsettling me today.”
Charlie has a different view. Charlie?
[Charlie Munger: If anything, I’m a little more repelled by the lack of virtue in how we as a nation run our financial affairs. Look at consumer credit... Things could get a lot worse.]
How do you think it will end? [Charlie Munger: Badly.]
We’re like an incredibly rich family. We sit on the porch of our huge farm – so big that we can’t even see the end of it – and each year, we consume 6% more than the farm produces. To pay for this, each year we sell or mortgage a little bit of the farm that we can’t see, so we don’t even notice. We’re very, very rich and the rest of the world is happy to buy from us or lend to us, so each year they take a piece of our valuable assets – and they work very hard.
But we will have to service this. If it goes on for a long time, our children will pay. We’re sending $2 billion per day [overseas right now].
What will cause a crisis? I don’t know. Does it reach a tipping point, or will there be an exogenous event?
I have a hard time conceiving of any scenario in which the dollar appreciates.
[Charlie Munger: The counter-argument is: what does it matter if foreigners own 10% of us over time, if the pie grows by 30%? [But I don’t buy this. Taken to its logical extreme,] what if we had no manufacturing and our only businesses were hedge funds?]
Imagine that if, instead of fighting the Revolutionary War, we’d instead agreed to give Britain 3% of our GDP each year. This might have looked good in 1776, but not to future generations. It’s like taxation without representation.
What can we learn from past blow-ups?
Warren Buffett: They’re all a little different, and they all have similarities. This one had origins in the mortgage field and residential real estate. Trouble in one area has a way of spreading to another area. In my lifetime, I can’t remember one where this particular residential real estate bubble sent out the kind of shock wave and exposure of so many other bad practices and weaknesses elsewhere like this one. There isn’t any magic to analysis. There are stupid things that won’t be done soon again; and not the same way again. But variations of it will occur again. Humans are what lead to stupidity and behavior. Primal urges, wanting to believe in the tooth fairy that pops up from time to time, sometimes occur on a very big scale. I have no great insights on the solutions.
Charlie Munger: It was a particularly foolish mess. We talked about an idiot in the credit delivery grocery business, Webvan. An Internet-based delivery service for groceries [that failed terribly]—that was smarter than what happened in the mortgage business. I wish we had those Webvan people back. I have a rule: The politicians are never so bad you don’t live to want them back. [laughter]
Do you think the bankruptcy process should be reformed?
We bought Fruit of the Loom out of bankruptcy and have invested in junk bonds [of bankrupt companies]. We got involved with Fruit of the Loom first by buying the bonds.
Munger: I think much of [how bankruptcy is handled] is pretty horrible. It’s a situation where courts themselves have gone into the business of bidding to attract bankruptcy proceedings. They’ve found that if they develop a process in which they over-pay people (lawyers, etc.), they can attract the most cases. It’s so upsetting to watch that I don’t follow it as much as I should. I’m an old man and I don’t like to have an upset stomach. [Laughter]
Buffett: We bought a lot of the Enron bonds called Ospreys. The Ospreys were a complex situation and we considerably more than tripled our money. In other situations, we got outbid, like with Burlington and Sitel. We owed all of the Sitel bonds, though, so we came out fine.
Anytime there’s something big and complicated, there might be some mispricing. But recently, [the mispricing has] been on the high side. Many people are looking [in this area], so it’s a field that does not have a lot of potential right now, but it will again.
Over the next 10-15 years, we’re likely to do something big in the bankruptcy area.
Munger: I remember the Eastern Airlines bankruptcy. The courts abused the senior bondholders to protect the employees and communities. Based on the law, you’d have come to one conclusion and the courts did the opposite.
There are a very interesting set of dynamics [involved in these types of cases].
Buffett: With Penn Central, a judge said it was too complex and came up with a quick, fast solution. It worked out well, but it wasn’t what the book said should be done. Judges can do what they want.
I remember a case in Cincinnati we talked about earlier [I’m not sure what he was referring to] and when we were on our way up there, I asked Charlie, “How much power does a judge have?”
Munger: And I answered, “As much as he thinks he has.”
Insurance pricing and risk?
In auto insurance, our policies are up more than premium volume, so the average premium is down a little bit. In reinsurance, in which we are a big player, there are great variances. For marine risks on the Gulf Coast (rigs, etc.), prices are up dramatically, as they should be. Premiums paid for this type of risk were $2.5 billion and the payouts were $15 billion [so obviously the pricing wasn’t sufficient].
In the past few years, we’ve been the largest writer of mega-cat insurance in the world, and I’m sure we will be this year. Prices are up a lot, but we don’t know if exposures are up even more. We don’t know if the experience of the last two years [the worst hurricanes in U.S. history] is to be relied upon more than the past 100 years. They tell you two different things. We do know that it would be silly to assume that the past two years [are outliers]. Atmospheric conditions and water temperatures have changed. This could change the propensity of hurricanes to occur and their severity. If the last two years are relevant [e.g., become the norm], then we’re not getting paid enough [for the reinsurance we’re writing currently].
The scary possibility is that the changes are continuous and that the changes in the past two years build up. It gets into chaos theory, whereby the output is not a linear relationship. You could dream up some very scary scenarios.
We are willing to write in certain areas and with certain coverages because we can sustain the losses. We’re willing to sustain big losses because [we have the financial strength and think we’re getting paid enough]. But it’s not like flipping a coin or rolling dice – there are many changing variables.
In the third quarter, we will have a lot of exposure to wind [damage claims] – but not as much as a couple of years ago. Prices are hardening in that particular area. If the prices go back to what they were last year, [we will write a lot less].
We don’t believe in modeling. The modelers don’t know a thing. It’s silly. We get paid for making guesses on it. Over a lifetime, we’ll know if we were right. Even if there are low losses this year, we won’t know if we’re right.
It’s still a business we like. If there’s a super-super catastrophe, say $250 billion (four times Katrina), we would pay maybe $10 billion. We could pay, and comfortably pay, but many others in the industry would be in trouble.
Over 5-10 years, we’ll know how well we did.
[Charlie Munger: The record of the past, if you average it out, has been quite respectable. Why shouldn’t we use our capital strength to get into volatile areas that make others uncomfortable?
We’re getting close to 10% of the float of the American property and casualty insurance industry, so we can’t continue to grow as fast as we have, but it will be attractive. I’m aware of the risks like pandemics – you’re aware of them too – and we get offers every day.
We think about $20 billion or $50 billion events and up. It’s a question of making judgments of whether we’re getting paid enough. We’ll know in 30 years. If we have a lot of money then, we’ll know we were right. If we take a big loss this year, it doesn’t mean we are wrong. What will hurricane losses be in 10 years? I don’t know, but I’ll keep thinking about it every day.
[Charlie Munger: The laws of thermodynamics are such that if the water is getting warmer – and I believe it is – the energy of the weather is going to go up.]
You have this possibility that a 1-2% change can lead to 100%+ increases in losses. That’s the game we’re playing, but if we don’t like the prices we’re being offered – and we haven’t in many areas – we don’t play and we’re happy to have someone take our place in line.
How do you manage insurance risk?
We are doing some things in insurance that have some correlations. For example, we have insured a lot of things in California and if you have the right earthquake at the right time, not only could National Indemnity and GEICO incur losses, but See’s and Wells Fargo would as well. And we used to own Freddie Mac [which would get hit as well].
I think about this a lot – it’s my job to think about the absolute worst-case scenario. No matter what happens, we’ll be OK.
The most likely mega-cat is a hurricane. In Long Island, there’s huge exposure [by the entire insurance industry]. The last big hurricane hit there in the 1930s [and insurance is being priced accordingly]. But everything that can happen will happen.
The most powerful earthquake in U.S. history – 9.0 – was in New Madrid, Missouri.
It’s Berkshire’s job to be absolutely prepared for the very worst. A few years ago, we didn’t have nuclear/chemical/biological risk exclusions [in our insurance policies] – we had huge risk, but it’s gone now.
We wrote a policy for $500 million in excess of $2.5 billion, not caused by a nuclear/chemical/biological attack, on a major international airport. There was a cap of $1.6 billion for business interruption, so there would have to be more than $900 million of property damage [before we’d have to pay anything].
We insured the [NCAA basketball] Final Four against being cancelled (not moved or postponed), excluding nuclear/chemical/biological attacks. We would have paid $75 million [in this event]. We also insured the Grammy’s in a similar way. We’re OK with losing a lot of money, as long as we’re being paid appropriately for the risk.
Nuclear/chemical/biological attacks are excluded from virtually all of our policies. We write it only when we’re specifically getting paid for it.
[Charlie Munger: We care more about thinking about things that have never happened. Think of a 60-foot tidal wave hitting California. Can you imagine?
Is there any other company that has attacked [reducing the insurance risk of] nuclear/chemical/biological attacks as well as us?]
No-one has attacked it more vigorously than we have. It’s Armageddon here every day. (Laughter)
My aunt, who died last year, had everything she had in Berkshire [stock. With investors like this,] it would be crazy to take any risks to jeopardize this [company] to make an extra $100,000 or add a point to the track record. Maybe if I had a 2/20 [incentive fee structure; 2% management fee and 20% promote], I’d behave differently, but I sure hope not.
Can you comment on the consolidation taking place internationally in the insurance industry?
Consolidation is a funny thing. I don’t think it solves many problems: putting two lousy businesses together usually makes one big lousy business. The winners in the insurance business are going to be the people that have some franchise based on specialized business, management talents, or terrific distribution.
GEICO is the lowest cost auto insurance distributor on all fronts. USAA is the same way; in fact their ways of operating are a lot like GEICO’s - but they only offer their products to a narrow clientele, whereas GEICO offers theirs to a much wider group. In general, we’re well-positioned in the industry; we have the best insurance vehicle in the business.
How do you price super cat insurance policies?
Try to be as realistic as you can on those numbers [the key variables] – err on being conservative – and then when you’re through, make sure you have a margin of safety.
In pricing earthquake insurance, look at the number of major quakes in past century – there have been 26 – so we’d assume 30 or 32 going forward (not 50 or we’d never write any business). If we calculated the resulting price to be $1 million, then we’d price it at $1.2 million to build in a margin of safety.
[Charlie Munger: Using the book Deep Simplicity [see link on page 33, below], you can predict how size is likely to be allocated. A standard power law will tell you how many earthquakes there will be of various sizes – many small ones, but big ones are less likely. So just do the math, apply the power law and calculate estimated damages.]
It’s difficult if someone wants to protect against a 9.0 quake, which happens only once every 1,000 years. But in investing, if it’s too hard, skip it.
Could you comment on fraud in the insurance industry?
[In response to a compliant by a shareholder that his insurance company had – he claimed – defrauded him on a Workman’s Comp claim, Buffett said:]
There is plenty of fraud in various aspects of insurance. In automobile insurance, we have fraud units.
We have lost more money in Workman’s Comp insurance than just about any other line in terms of aggregate dollars. It’s been a tough period. We have one small direct seller of Workman’s Comp insurance in California, and then Gen Re does Workman’s Comp reinsurance, and it’s been a bloodbath – the rates haven’t covered the losses. There’s been a fair amount of fraud, especially in the direct lines.
Many companies that have been in the Workman’s Comp business, especially in California, wish they hadn’t. They haven’t made money from it.
[Charlie Munger: If a company gets into a lot of trouble by fraud practiced on it, and its own affairs are disrupted, then it’s just human nature to give customers a hard time.]
But the main fraud isn’t by insurance carriers against small businessmen, but by the doctors, lawyers, etc. doing it against the carriers.
Opinion on the likely housing bubble? (2005)
Americans feel very good about home ownership – for many people, it’s been their best-behaving investment. If it’s a bubble and if it’s pricked, it could affect some Berkshire businesses, but it would also let us put a lot of money to work [referring to a likely crisis that would depress stock prices and let them invest some of the $40+ billion cash hoard].
We’ve not made our money betting on macro stuff like foreign exchange; instead, it’s from buying cheap stocks like PetroChina.
25 years ago, we saw the same thing [a real estate bubble] with Nebraska farmland. People fled cash, saying “cash is trash.” A farm 30 miles north of here sold for $2,000/acre in 1980; I bought it later for $600/acre. People went crazy and the consequences were huge. Many banks failed, even ones that had survived the Great Depression.
I don’t know where we are with housing – people may behave differently because they live in it. But when you get prices increasing at a far greater rate than construction costs or inflation [there can be problems].
[Charlie Munger: In parts of California and in the Washington DC suburbs, there’s a bubble.]
I sold a house in Laguna Beach, CA for $3.5 million. The house was only worth about $500,000, so the land was being valued at $3 million. It was only a fraction of an acre, so the land was being valued at $60 million per acre. That’s a pretty fancy price for almost any land.
[Charlie Munger: One of the Directors of Wesco told me that a modest house next to his recently sold for $27 million. There are some very extraordinary housing price bubbles going on and the consequences could be serious.]
The financing terms have become easier and easier as prices have risen, which is contrary to normal [and prudent] practices. But the financing process has become so disintermediated that the mortgage buyer doesn’t care. The easier financing has led to a boom in prices.
The Nebraska farm bubble was fueled by banks that historically had been conservative but went crazy. They said that a farm was an asset-appreciation investment, not an income investment – in other words, they were playing the greater fool game.
The rest of the world is saving. They’re investing $2 billion/day in the U.S. Some say they have so much confidence in the U.S. that they want to invest, but this is silly. They invest because they have to.
[Charlie Munger: It’s obvious that easy financing [for houses] is fueling big price increases.]
Consider the following fanciful illustration. Let’s say we had a fixed population in Omaha and no new houses were built, but each year everyone sold their house to their neighbor and moved. In year one, the price was $100,000. In year two, the price jumped to $150,000, but Fannie and Freddie guaranteed the mortgage and sold it to Asian investors. This is an influx of $50,000 to the family income. In year three, the price jumps to $200,000 and the same thing happens.
Obviously, it is transparent what’s happening here, so it wouldn’t really happen, but you can have accidental behavior that leads to certain aspects of this.
[Charlie Munger: There are Ponzi effects in any economy, and you can see that here.]
[Charlie Munger: In a corporation like Berkshire, a subchapter C, owning real estate is very disadvantageous.
Investing in real estate is having a bubble of its own. My friends who own real estate are selling their worst assets and getting better prices than they’d imagined.]
I have less than 1% of my net worth outside Berkshire and when the Nasdaq hit its high, I had nearly all of it in REITs, which were selling at a discount to their liquidation values. REITs are quite attractive now, especially compared with 5-6 years ago when they were very unpopular.
It’s better to pay attention to something being scorned than championed. Munger: And REIT accounting is phony. Buffett: Other than that, we love REITs. (Laughter)
Munger: Some of the worst sins in manufactured-housing financing have gone over to the financing of stick-built homes. A lot of ridiculous credit is being extended in the U.S. housing sector. There was a horrible aftermath in manufactured housing and my guess is that we’re likely to see something similar [as a result of the unwise credit being extended in the overall housing sector].
Buffett: Look at the latest 10-Qs of financial institutions and the levels of accrued, but not paid, interest. You’ll see some interesting things. It’s growing rapidly, which means the lenders are booking earnings, but not receiving the cash [e.g., borrowers are falling behind in their payments].
Dumb lending always has its consequences. You can have an epidemic and not realize it until you’re very far into it. You had it in commercial real estate in the 1980s and the RTC [Resolution Trust Corporation] was the result. A developer will build anything he can get financing for.
Munger: Some of the dumb lending is facilitated by contemptible accounting. The accounting profession [has continued to disgrace itself here].
Buffett: We developed a piece of property for 20 years in California.
Munger: I think we got our money out, plus interest [e.g., a terrible rate of return, given the time and effort].
Buffett: It’s not an exaggeration. The land value was $5-6 million when we sold. We finished at the wrong time. What do you think it would be worth now, Charlie?
Munger: $100 million.
Buffett: The swing in property values has been huge in some markets. What we see in our residential brokerage business [HomeServices of America, the nation’s second- largest realtor] is a slowdown everywhere, most dramatically in the formerly hottest markets. The high end and where properties were bought for investment and speculation are doing the worst.
If you buy a house for $300,000 and take a $270,000 mortgage, you’re going to stay there and continue to make your mortgage payments, even if the market value of the house falls (unless something bad happens to you like losing your job). But if you have investors and speculators holding the properties – effectively day traders in the condo market – that kind a speculation can produce a market that can move in a big way. First the buying and selling stops and then the market reopens. With stocks, they will trade every day, so you can’t kid yourself. If you own GM stock and it’s down on Monday, you know you’ve taken a loss. But in housing, there’s always the hope that you can find the one seller who will pay the price you want, who hasn’t heard that the market has collapsed.
In [Miami-]Dade and Broward counties in Florida, the average condo costs $500,000. [I may have the numbers slightly off here:] Not long ago, there were 3,000 condos listed and 2,900 sold every month. Today, there are 30,000 condos listed – worth $15 billion – and only 2,000 per month are selling. The whole supply-demand equation has changed.
We’ve had a real bubble to some degree. I would be surprised if there aren’t some significant downward adjustments, especially in the higher end of the housing market.
Munger: There’s a bubble among high-end apartments in Manhattan, but in Omaha, housing prices are reasonable.
How do you feel about the current real estate environment?
If you are buying to own a home, that is fine. Otherwise, it seems to be getting into bubble territory. We're not excited about real estate because generally there is not enough return at current prices.
Your views on the securitization of real estate?
There has been enormous securitization of the debt too of real estate and that is one of the items right now that is really clogging up the capital markets. The mortgage back securities are just not moving, commercial, not residential mortgage backs. But I think you are directing your question at equities probably. The equities, if you leave out the corporate form, have been a lousy way to own equities. You have interjected a corporate income tax into something that people individually have been able to own with a single tax, and to have the normal corporate form you have a double taxation in there. You really don't need it and it takes too much of the return.
REITS have, in effect, created a conduit so you don't get the double taxation, but they also generally have fairly high operating expenses. If you get real estate, let's just say you can buy fairly simple types of real estate at an 8% yield, or thereabouts, and you take away close to 1% to 1.5% by the time you count stock options and everything, it is not a terribly attractive way to own real estate. Maybe the only way a guy with a $1,000 or $5,000 can own it but if you have $1 million or $10 million, you are better off owning the real estate properties yourself instead of sticking some intermediary in between who will get a sizable piece of the return for himself. So we have found very little in that field.
You will see an announcement in the next couple of weeks that may belie what I am telling you today. I don't want you to think I am double crossing you up here. But generally speaking we have seen very little in that field that gets us excited. People sometimes get very confused about--they will look at some huge land company, like Texas Pacific Land Trust, which has been around over 100 years and has got a couple of million acres in Texas. And they will sell 1% of their land every year and they will take that (as income? Garbled) and come up with some huge value compared to the market value. But that is nonsense if you really own the property. You can't move. You can't move 50% of the properties or 20% of the properties, it is way worse than an illiquid stock. So you get these, I think, you get some very silly valuations placed on a lot of real estate companies by people who really don't understand what it is like to own one and try to move large quantity of properties.
REITS have behaved horribly in this market as you know and it is not at all inconceivable that they become a class that would get so unpopular that they would sell at significant discounts from what you could sell the properties for. And they could get interesting as a class and then the question is whether management would fight you in that process because they would be giving up their income stream for managing things and their interests might run counter to the shareholders on that. I have always wondered about REITS that have managements they say their assets are so wonderful, and they are so cheap and then they (management) go out and sell stock. There is a contradiction in that. They say our stock is very cheap at $28 and then they sell a lot of stock at $28 less an underwriting commission. There is a disconnect there. But it is a field we look at.
Charlie and I can understand real estate, and we would be open for very big transactions periodically. If there was a LTCM situation translated to real estate, we would be open to that, the trouble is so many other people would be too that it would unlikely go at a price that would get us really get us excited.
Where do you see the residential real estate market going in the next year or two?
Buffett: We don’t know. I see a lot of data. In the last few months, you’ve seen a real pick up in activity in California in the low to medium-priced homes at or below $750,000. There are many different markets, and many California markets will be difficult. There’s been no bounce in prices yet, though activity is up on lower prices. Looking at real estate brokerage data, it looks like something close to stability in California in the $750,000 and less segment at these much reduced prices. Mortgages being put on books today are much better than before. Interest rates are down and it’s easier to make payments. It’s improving. There are about 1.3 million households created in a year, but in a recession it tends to be lower. If you create 2.0 million houses a year, then you run into trouble. There’s an excess inventory of about 1.5 million now. With housing starts down to 500,000 [annual rate], the excess supply will be absorbed. We are eating up the excess at a rate of 700,000 – 800,000 units per year. It takes a couple of years. There are two options: blow them [the excess inventory] up—I hope they blow up yours [Charlie’s] instead of mine—or sell them. South Florida will be tough for a long time. You can’t do it in a day or a week, but it will get done. Then prices will stabilize. Then we can go to [building] one million per year. The situation is being corrected.
Munger: In places like Omaha, I would buy a house tomorrow, if I were a young person.
Buffett: There are approximately 80 million houses in the country, and about 25 million do not have a mortgage. The situation is being corrected.
Can you comment on the subprime market?
The subprime market, encouraged by lenders, intermediaries, builders, etc., led to a lot of people buying houses they couldn’t afford. There will be consequences for these people, but the question is whether it spreads. If unemployment and interest rates don’t go up, then it’s unlikely this factor alone triggers anything in the general economy.
In the 10Qs and 10Ks I’ve read, a high percentage of loans allowed people to make tiny payments early on, made up by higher payments later. I think this is dumb lending and dumb borrowing because someone who can only make 20-30% payments now isn’t going to be able to make 110% payments in the future. Those people and institutions were betting that house prices would keep going up. When this stops, you have a big supply of houses come on the market, like we saw in manufactured housing. You’ll see plenty of misery in that field – you’ve already seen some. But I don’t think it’ll be any huge anchor for the economy.
Munger: There’s been a lot of sin and folly, a lot of it due to accountants who let lenders book profits when no one in their right mind would have allowed them to book profits. If accountants lie down on the job, you see huge folly.
It’s in the national interest to give loans to the deserving poor. But the moment you give loans to the undeserving poor or the stretched rich, you run into trouble. I don’t see how people did it and still shaved in the morning, because looking back at them was a face that was evil and stupid.
Buffett: You’ve seen some very interesting figures in the past few months on people who didn’t even make the first or second payment. That shouldn’t happen. We saw this is in the manufactured-home sector. When someone only has to make a $3,000 down payment to someone who gets a $6,000 payment [the salesperson’s commission], then believe me, you’ll see a lot of bad behavior.
Securitization accentuated the problem. A local banker wouldn’t allow this because he’d see what’s going on, but when the loans are bundled and sold by Wall Street, that discipline disappears.
It will be at least a couple of years before real estate recovers. In some areas of the country, the [housing] inventory overhang is huge. The people who were counting on flipping the homes are going to get flipped, but in a different way.
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