Mrs. B’s departure did not hurt Berkshire, which hit an all-time high in September 1989 of $8,750 a share. But it is a strange truism of Buffett’s career that he felt most apprehensive during bull markets. He was gloomy about the lack of opportunities, and gloomy even about Berkshire.
His response was nothing short of brilliant. In a mirror image of his deals with Gillette, USAir, et al., Buffett raised $400 million by selling bonds that were convertible into shares of Berkshire. The people who bought this paper got a fixed return and a “lottery ticket” on Berkshire’s stock.
This time, Buffett’s terms were sweeter than sugar. His interest rate was only 5.5 percent. The low rate was a measure of the investors’ faith that Berkshire’s share price would continue rising. (They were betting on the lottery ticket.)
What’s more, since these were “zero-coupon” bonds, Berkshire would owe interest, but not actually pay it, until the bonds matured, fifteen years later. But owing to a quirk in the tax laws, Berkshire could deduct the interest all along, as though it were paying.
And there was more. Berkshire could redeem the “zeros” in three years. Thus, the investors were betting not just that Berkshire’s stock would rise, but that it would do so in a hurry. Lost in the shuffle was the fact that Buffett was making exactly the opposite bet.
Two weeks later, in October, a proposed LBO of United Airlines collapsed. Arbitrageurs—Buffett had quit the game months before-suffered huge losses. The stock market plunged 191 points in a day. The junk-bond market crashed; the takeover game stopped in its tracks. Within months, Drexel Burnham was dead. Wall Street’s long love affair with debt was over. By early 1990, the Street was in the tank, and Berkshire was under $8,000.
In his annual letter, Buffett confirmed his gloominess, predicting that Berkshire’s net worth was “almost certain” to drop (for the first time in his tenure) in one of the next three years. He tied together Berkshire’s recent history and Wall Street’s current crisis with a seemingly innocent thread: many of the now-toppling LBOs, such as Federated, the corporate parent of Bloomingdale’s, had also been financed with zeros. Of course, Buffett had a larger theme in mind. On Wall Street, it was often the good ideas that got you into trouble, for what the wise did in the beginning, “fools do in the end.”36 Thus it was with LBOs and zero-coupon bonds.
As was his style in such essays, Buffett started small and in the distant past. He invited readers to “travel back to Eden, to a time when the apple had not yet been bitten.”37
If you’re my age you bought your first zero-coupon bonds during World War II, by purchasing the famous Series E U. S. Savings Bond, the most widely sold bond issue in history.
Nobody called it a zero-coupon, but that’s what the Series E was. The interest was paid in a lump sum, when the bond matured. The ordinary Americans who bought the Series E were no fools. Since the Treasury was the surest possible credit, they slept soundly, knowing that their money was safely compounding at 2.9 percent per annum.†
In the 1980s, investment banks invented a zero-coupon for large lenders. These—like Berkshire’s—were rated Triple-A. Then the bankers discovered that zeros and the equivalent pay-in-kind (PIK) bonds could be used to finance LBOs. The appeal was obvious: since no cash payments were required for years, bidders could be induced to borrow any sum at all. Buffett’s description rendered this shell game suddenly self-evident:
To these issuers, zero (or PIK) bonds offer one overwhelming advantage: It is impossible to default on a promise to pay nothing. Indeed, if LDC governments [Mexico, Brazil, etc.] had issued no debt in the 1970’s other than long-term zero-coupon obligations, they would now have a spotless record as debtors.
Buffett suggested that investors offer the bankers a taste of their own medicine, a signature Buffett stroke that made it intuitively clear, even to a person on Main Street, that Wall Street was dealing in extremely funny money.
Our advice … zip up your wallet. Turn the tables by suggesting that the promoter and his high-priced entourage accept zero-coupon fees, deferring their take until the zero-coupon bonds have been paid in full. See then how much enthusiasm for the deal endures.
Such essays, though, were guides to the broad strokes; of his strategy they revealed nothing. Indeed, Buffett was a master dissimulator.
At the very moment that his junk-bond critique was rolling off the press, Buffett was scooping up one of the largest bundles of junk bonds ever—$440 million of RJR Nabisco paper. RJR Nabisco’s bonds had collapsed with the general market, but in Buffett’s view, the market had overreacted. (After all, RJR Nabisco was still selling a high-margin product to “addicts.”) His purchase of junk bonds might seem hypocritical, but it was not. Buffett saw a moral hazard in selling a junk bond that would likely never be repaid. Buying a bond was different. To the investor, no financial instrument was “evil per se”;38 it was a question of price.
After the purchase was disclosed, Dr. Benjamin Graham, the son of Buffett’s mentor and a Berkshire stockholder, wrote to protest Berkshire’s investment in tobacco. Buffett replied that while he wouldn’t manufacture cigarettes, he had no problem with owning traded tobacco securities—or, for that matter, a newspaper that advertised the product. “I’m not sure that this is strictly logical,” he admitted, but in a complex world, he deemed it a practical way to draw the line.39
With Iraq’s seizure of Kuwait, in August 1990, the “credit crunch” snowballed into a full-blown recession. New decades do not necessarily portend new eras, but this one did. In the eighties, spirits had run high. Buffett, conversely, had hewed to caution. In the nineties, Wall Street rediscovered fear. People who had lent money wanted it back; companies that once could have borrowed millions found the window slammed shut.
Corporate bankruptcies and junk-bond defaults (the “big bang” that Buffett had predicted at Columbia in 1985) lit up the map. Fred Carr’s insurance company—stuffed with junk bonds—became the biggest insurance failure in history. Banks, just reborn from the foreign-debt crisis, found they were up to their ears in homegrown deadbeats, such as LBOs and commercial real estate. A contagion of bank failures moved like a storm front from Texas to Colorado, New England, and the mid-Atlantic states. Serious people gathered at investment seminars and discussed whether Citicorp or Chase Manhattan would fail.
From Buffett’s point of view—Buffett and Fred Carr were always out of synch—it was an ideal time to take a little risk. Berkshire’s stock, it was true, had collapsed with the rest (its low for the year was $5,500, down almost 40 percent from its peak). But it was at such times that Buffett was at his best. Rhinophobia might get hold of him when prices were high. But when the world turned gloomy, his instinct was deadly.
During 1990—the worst year for banking since the Great Depression—Buffett bought 10 percent of the stock of Wells Fargo, the San Francisco banking giant. California real estate was just beginning to turn down; the misery of its banks was expected to be deep and long-lived. And Wells Fargo had lent more money to California real estate than any bank in the country.
Buffett, of course, knew that. Generally, Buffett did not like banks. An outsider had no way of gauging the soundness of their loans until it was too late. But he had been pining for this bank for years.40 Wells Fargo had a strong franchise in California and one of the highest profit margins of any big bank in the country. Its chairman, Carl Reichardt, was a cost-cutter in the Tom Murphy mold. During an earlier rough period, Reichardt had sold the company jet—a sacrifice Buffett could appreciate—and frozen the salaries of the top brass. And Reichardt had largely avoided the periodic fads, such as lending to Latin America, that had undone other banks. As Buffett knew, Reichardt and Paul Hazen, the bank’s number two, had cut their teeth on property loans in the 1970s and had escaped the real estate debacle of that decade with barely a scratch.
None of this meant that the outlook for Wells Fargo over the next year or so was rosy. But Buffett was thinking about a much longer period than the next year
or so. The bank was well capitalized; it ought to survive the current trauma. Indeed, Buffett reported, a bad year “would not distress us.”41
And because other people were distressed, Buffett was able to pick up $290 million worth of stock at the fire-sale average price of $58 a share, or five times earnings. That was down from a recent high of $84.
After Buffett invested, Wells Fargo’s portfolio began to take in water. Wall Street wrote it off; Barton Biggs, the chief strategist at Morgan Stanley, said he had no idea if Wells Fargo would survive and Warren Buffett didn’t either.42 In the spring quarter of 1991, Wells Fargo took a massive reserve against the possibility that loans would not be repaid. Earnings plunged to twenty-one cents a share, compared with $4.40 in the corresponding quarter a year earlier. Buffett responded with aplomb; in fact, he asked for regulatory approval to double his investment.
Wells Fargo, by then, was the darling of short-sellers. It had almost $15 billion in commercial real estate loans—two and a half times as much, per dollar of equity, as its neighbor Bank of America. Half of Wells Fargo’s real estate loans were in the terra infirma of Southern California, the new fault line of American credit. In Los Angeles, where the boom economy had turned to bust, developers were quixotically racing to complete new skyscrapers that they now had no hope of renting. In Orange County, 22 percent of the office space was vacant. A bear on Wells Fargo, writing in Banon’s, sardonically observed that the “Sage of Omaha, Warren Buffett” would be stuck with all that.43
Even many within Buffett’s crowd saw the bet on Wells Fargo as a breaking of the faith. Scott Black, a Graham-and-Dodd-style money manager, said, “It upset me. Warren made a mistake,” as though the heavens should have forbidden it. People who had been appalled by the excessive leverage of the eighties had an emotional stake in seeing the guilty get their just deserts—and real estate lenders were “guilty.”
Buffett also disapproved of excessive leverage, but he stripped the emotion out of his calculations. At a certain price, he was happy to buy a bank, or even a junk bond. During the height of the gloom, a Manhattan friend called to “warn” him that the smart money was saying that Wells could go under. Buffett said calmly, “We’ll see who’s right.”
Unhappily for Buffett, the gloomy times were over all too soon. When the United States opened fire on Iraq, early in 1991, the stock market rallied. The fighting ended in six weeks, but the rally did not. By July, the Dow had broken 3,000. The combination of more cash at Buffett’s disposal and fewer places to put it could be counted on to induce a new spell of rhinophobia. When Buffett got a call from James D. Robinson III, chairman of American Express, he was all ears.
Robinson, the courtly son of an Atlanta banking family, was a fellow Coca-Cola director and a social chum of Buffett’s. An habitué of boardrooms who held thirteen directorships, Robinson projected a refined, statesmanlike air. His dark-wood, river-view office seemed to whisper “old money.” Personally, Buffett was fond of Robinson. What he thought of him as a CEO of American Express was not so clear.
The company’s charge cards and traveler’s checks had remained a very good business. During the most recent decade, their profits had galloped ahead at an 18-percent-a-year clip. But Robinson’s shareholders had never seen that 18 percent.
Robinson had frittered away the profits of this very good business on a series of bad ones—in insurance, banking, brokerage, even an art gallery specializing in nineteenth-century American paintings. Eager to follow the 1980s fad for “financial supermarkets,” Robinson had pumped a staggering $4 billion into Shearson. But supervision was lax (Shearson “invested” $26 million in a “conference center” at a Colorado ski resort), and the investment bank had repeatedly needed bailing out. To make matters worse, American Express had a habit of not coming clean with the bad news until after the fact.44
Robinson had managed to elude the blame for such miscues, partly thanks to his busy public relations department and partly because he had stacked the board with captive directors. One such captive, Henry Kissinger, pocketed $350,000 a year in consulting fees from the management he was supposedly overseeing.
Despite Robinson’s good press, Buffett was hardly unaware of his record. In 1985, Buffett had attended an American Express board meeting, when the company was considering selling its Fireman’s Fund insurance unit to a group that included Buffett. Buffett gave the board some advice: it should sell Fireman’s to somebody and focus on American Express’s one truly splendid business.45 A bit later, when insurer GEICO bought a chunk of American Express’s stock, Buffett had called GEICO to express his concern. Though Buffett didn’t put it in such terms, Robinson’s record was a compendium of the managerial sins that Buffett had bewailed in his letters.
But when Robinson called, all this was forgotten. Buffett hopped on the Indefensible for New York—seized, apparently, by one thought: the memory of his investment in American Express a quarter century earlier, which had been the first big gusher in his career. Now, as before, the company was in trouble. Just weeks earlier, its credit had been downgraded. When Robinson asked for a $300 million investment, Buffett quickly agreed.
As Buffett noted at the time, with the market at a high, he was finding few things he liked, and he did like American Express’s basic business. Still, it is hard to account for his saying “We’re buying to be in with Jim [Robinson].”46 Buffett’s friends were stunned. He had even agreed—reluctantly, but nonetheless—to a term that capped Berkshire’s potential upside. Jack Byrne, who was an American Express director, told Business Week he would have thought that Buffett’s “genes” would have forbidden such an agreement.47
When they spoke privately, Byrne realized that Buffett regarded his earlier American Express investment as a milestone in his career and was eager to play a part in restoring the company. Buffett told him, “This is coming home again.” Of course, he had also come home to GEICO and to the Washington Post He liked these old shoes, just as he liked investing in the soft drink that he had delivered as a boy. Replaying these ventures transported him to a comforting time, when he had been young, and had had the likely prospect of many more years ahead. It had also occurred to Munger that his partner’s career was full of “odd coincidences.” “Warren likes his past,” Munger admitted.
By August 1991, many of the recent additions to Buffett’s portfolio were troubled. Wells Fargo was on the verge of a disastrous quarter. There was major trouble brewing at American Express, which was facing a revolt by restaurants, a decline in the number of card holders, and slumping profits.
Among the much-criticized “whitemail” deals, Gillette had soared, enabling Berkshire to convert to common stock. Other Gillette holders were also better off, since the stock was twice as high as what Perelman had offered for it. Peter Lynch, the mutual-fund manager and a Gillette shareholder, said, “The deal with Buffett helped everyone.”
Few would have said the same of Buffett’s deal with Champion. Earnings had plunged by 85 percent, though Berkshire wasn’t suffering, since its dividend was fixed. Meanwhile, Sigler, the CEO, had awarded himself options on 250,000 more shares at a price well below the company’s book value.
USAir was doing worst of all. Almost on the day that Buffett had invested, a fare war had broken out. Then, in the wake of the Persian Gulf War, air travel had collapsed. USAir found itself with high employee costs at a time of intense cost pressure. It lost a staggering $454 million in the year after Buffett’s investment, and its bleeding was far from over.
At one point, Seth Schofield, the chief executive, called Buffett to apologize for the way his investment was turning out.
“Seth, I want you to remember one thing,” Buffett shot back. “I called you, you didn’t call me. So I have no one to blame but myself if it doesn’t work out, and let’s let it go at that.”
Buffett blamed himself in a deeper sense, too. He had understood the dynamics of airlines—lots of competition, high fixed costs—but invested anyway. In public, he w
as up-front about this mistake. With a touch of Will Rogers, he wrote to his shareholders, “No one pushed me; in tennis parlance, I committed an ‘unforced error.’ ”48 It was easily his worst investment, and violated Buffett’s own guidelines. Ironically, the investment was probably a good thing for other USAir holders, as it injected the deeply troubled airline with much-needed capital.
These blemishes in Buffett’s portfolio were easily outweighed by the likes of Coca-Cola, Gillette, and the RJR Nabisco junk bonds—on which he turned a fast profit of roughly $200 million.49 Berkshire’s net worth continued to rise, in defiance of Buffett’s prophecy. And the stock rebounded smartly; by August, it was at $8,800. What’s more, the problems at his companies did not require Buffett to get personally involved. He liked to say that he had “arranged” his life so that he needn’t do anything he didn’t like. In the summer of 1991, this was true. He said his biggest worry was Nebraska’s upcoming game with Colorado.50
Buffett’s broad defense of the whitemail deals—that the companies would benefit from having “a major, stable, and interested shareholder”—had yet to be tested. Perhaps it never would be. But the controversy had faded. Even the first one, often-troubled Salomon Brothers, was enjoying a record year.
* The term is from Fred Schwed, Jr.’s quaint classic Where Are the Customers’ Yachts? Schwed seemed to have known a Buffett or two in his day. He observed that rhinophobia is apt to strike “economical souls who do not believe in frittering away their money on food and drink and momentary pleasure. If they play bridge of an evening for a quarter of a cent and lose $17, they are liable to go home in a pretty depressed state of mind.”11
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