Warren also noticed that credit derivatives are often mispriced. When this occurs, he earns upfront premiums for taking default risk on baskets of high-yield ( junk) bonds. When junk bond yields are very high and most investors avoid them,Warren will enter the market when he can be handsomely compensated to take the risk of carefully chosen companies. Warren invests when the prices are right; but he is happy to do nothing for years when the price for the risk is not right.
Warren is aided by the fact that most investment banks use sophisticated Monte Carlo models that misprice the transactions. Some of the models rely on rating agency inputs, and the rating agencies do a poor job of rating junk debt. Ratings guru Arturo Cifuentes, a managing director at R.W. Pressprich & Co., is one of the original developers of Moody’s collateralized debt obligations (CDO) model. Among other serious problems, he notes that Moody’s released a report in 2005 (and again in 2006) that shows that when judged by impairment rate, there is no difference in performance between CDO tranches with a junk rating of BB- and those with an investment-grade rating of BBB.10 Other models rely on the relationships between historical market prices or on historical yield spread data.
If you play with coins or dice, you can learn a lot about the outcomes by flipping and throwing them thousands of times and recording the results. A Monte Carlo simulation uses a computer to throw a whole lot of random inputs into a model. It is like shaking a newly made chair to see how stable it is. Financial firms use correlation models to look at what happens when corporations default.The model tries to determine if other companies will behave similarly when one company strengthens or weakens. The models are highly unstable. They are like a chair that collapses beneath you as soon as you sit on it. Small changes to model inputs result in huge changes to the results.
If you play with coins or dice, you know exactly what your inputs are and you can model all potential outcomes. You can examine the coins (heads or tails per coin), and you can model all of the possible outcomes.You can examine dice (one to six dots on each face of each cube), and again, a mathematical model can describe all potential outcomes. We do not have to guess at the inputs for dice and cards; they are known in advance and the relationship between the inputs does not change, even though we may use a Monte Carlo model to randomize the inputs (the flips and tosses).
The inputs to credit models are a bit of a guess, since we rely on data approximations to come up with the inputs in the first place. Furthermore, the relationships between the inputs can change. Most of the data describing how one corporation behaves in relationship to another is based on market prices such as stock prices or the prices of credit default swaps based on corporate debt. Moreover, there is very little of this already-suspect data to work with. The results are guesses about relative price or yield spread movements, which result in a guess about the correlations. When a credit upset occurs in a financial sector, correlations that were previously fractional numbers tend to converge to one. Everything seems to fall apart at once. A model will calculate the wrong answer to nine decimal places, but it cannot tell you it is the wrong answer.
The biggest problem with the models is that even if they temporarily get the correct answer, they do not tell you what you need to know. Wall Street estimates asset correlations instead of the necessary default correlations. Furthermore, the overwhelming flaw in the methodology is that if you want to make up a default correlation between two companies, you must make the false assumption that default probability does not vary, but of course it does. Even if the models measured the default probability of individual companies—and they do not—if a company defaults, you still have to guess the recovery rate, the amount left over, if any, after all obligations are paid. You cannot solve for two independent items of information from a single piece of information such as a letter grade or a price. You cannot get both the probability that a company will default and the amount of money you will have left if it does default.
Warren warns Wall Street it is about to get into a fight it cannot win, and Wall Street comes anyway. The models are incapable of generating the information Warren has in his head. Warren says he doesn’t use a model, but he does. Warren himself is the model. He has spent so much time reading annual reports that he has a good idea of whether or not a company will default, and if it does, how much will be leftover after everyone else is paid off. Moreover, he knows how businesses affect each other and how the impact may change in a variety of scenarios. He is much faster and much more accurate than a misguided computer model. Warren does not rely on a price since that is what you pay. He relies on value because that is what you get. Unlike the computer models, Warren does not guess at the inputs. He does not use a potentially irrational price as his input.Warren sizes up each business and relies on his rational assessment of value.
A couple of years before I met Warren, a Wall Street firm paid Berkshire Hathaway to take the risk of the first corporation to default in a basket of junk debt.Warren only considers deals he knows are mispriced, and he has a couple of conditions. He chooses the specific corporate names; he refuses “diversified” portfolios containing a large number of corporations. He does trades in massive size—$100 million or more, if possible.
The following is a simplified example. If one of a handful of pre-chosen corporations defaults, Berkshire Hathaway pays the original full amount for the debt, which is 100 percent of the first corporate name to default. Berkshire Hathaway then gets the recovery value—the market price of the debt.This price will depend on the remaining value of the company. Warren happily enters this type of credit derivative trade, when he can create a margin of safety—when Wall Street pays him so handsomely in an upfront premium that it exceeds anything he might lose if one of the companies defaults.
When Collins & Aikman defaulted and filed for bankruptcy in June 2005, Berkshire Hathaway recovered 35¢ on the dollar, or put another way, it “lost” 65¢ on the dollar. David Stockman, the director of the Office of Management and Budget during President Ronald Reagan’s administration, was Collins & Aikman’s CEO and stepped down the week before the bankruptcy was announced. In March 2007, he and other top officers were charged by a New York federal grand jury with conspiracy, several counts of fraud, and obstruction of justice. Allegations are that, among other things, loans were disguised as revenues and revenue was booked before it was earned. U.S. Attorney Michael Garcia said: “They resorted to lies, tricks and fraud.”11 Warren’s margin of safety greatly increases the likelihood he will make money, even when an unexpected event like this occurs.
It is more important to have a margin of safety to protect oneself against a Black Bart—someone fancying himself to be an offspring of the famous Wells Fargo stagecoach robber—than a rare Black Swan type market event. Berkshire’s “loss,” given that the Collins & Aikman default occurred, was 65¢ on the dollar, but Berkshire had received much more than 65¢ on the dollar in upfront premiums. On average, Berkshire Hathaway had taken in around 75¢ on the dollar in upfront premiums.
Warren does these trades in very large size. For example for every $1 billion of transactions, Berkshire stands to lock in $100 million (or more), if there is a default. Meanwhile, it has the use of $750 million in premium money it puts to good use. In 2005, Warren had $1.5 billion in premiums to put to work. Isn’t that adorable?
Normally, first to default trades are viewed as the riskiest trades, and junk debt is viewed as the riskiest kind of asset; but Warren builds in a margin of safety that makes this a wise investment as long as Wall Street misprices the risk.Warren Buffett has figured out the safest way to take junk risk in the history of junk debt.
Investment banks could put on the same trades if they did fundamental analysis of the underlying companies, but they are too busy playing with correlation models. Banks and investment banks have become invisible hedge funds putting risk on their balance sheets that they cannot quantify. Meanwhile, Warren Buffett models the risk in his head and profits.
Warren has anothe
r advantage: Wall Street underestimates him.
In the fall of 2006, I was talking to a friend in New York, and I mentioned that Warren Buffett and I have similar views on credit derivatives, and—now comes the bragging part—I had met Warren Buffett. The problem with bragging is that it often backfires. This was one of those times. My former colleague, a Wall Street structured products “correlation” trader, wrinkled his nose and sniffed: “That old guy? He hates derivatives.”
Warren continues to give Wall Street fair warning. In that way, Warren is like Ronald Reagan, who said during his presidential campaign debate with Mondale that he refused to make age an issue:“I will not exploit my opponent’s youth and inexperience.”
By now we were past hungry, and Warren drove the few miles to the restaurant. We discussed some of the personalities I had dealt with when I started my business. Vetting new people takes a lot of time, so I only deal with people I have worked with in the past or who have solid referrals. Clients who know me meet my terms of business. Early on, a large famous pension fund used a ruse claiming it wanted consulting services; all it really wanted was a two-hour conference call with its management, during which it garnered valuable information.That is bad enough, but a consultant loses twice when insult is added to injury. When people owe you a moral debt but do not have a legal obligation, you will get nothing—and worse—they will demean you to suppress their guilt. In contrast, when a client pays a nonrefundable upfront retainer, the client—having already acknowledged your value—rolls out the red carpet. Everyone shows up on time for meetings.
Warren commented that I am in a position that I should not have to deal with difficult people. There are so many good people to work with that it isn’t necessary to spend time with those who do not recognize the value of my services. I had independently come to the same conclusion, but had not decisively acted on it. Warren said the right words at the right time, and furthermore, the words came from the right person. Crash! I tossed a piece of old and heavy baggage out the window of a musty attic in my memory palace.
When we entered the restaurant, the rest of the diners seemed not to notice us, presumably accustomed to seeing Warren Buffett at lunch. We sat down to a meal of roast beef and mashed potatoes. I had already mentioned to Warren that I take thyroid medication and a careful diet helps maintain balance, so I ordered water. The popular press talks about Warren’s love of Cherry Coke. Warren famously asks people to have a Coke—even if they just open it and do not drink it—since “we make money on every twelfth can.” At the May 2007 annual meeting, Warren showed a comedy film skit with LeBron James in which he admonished James: “You will drink Coke.” Perhaps in deference to not having something his guest was not having, Warren ordered water, too. If you must have water, make sure it is Dasani, a Coca-Cola product.
While we discussed not wasting time with people who don’t recognize your value, Warren asked me what I was doing for my personal account. There is a real opportunity cost to dealing with difficult people above and beyond the immediate drain of time and energy. One could be using the time to identify investment opportunities. I am at a stage where I can lose more money in forgone opportunities than I can make on certain types of client work.
Warren seems to feel there is nothing stopping me; I have critical mass. A couple of years after our lunch, I sent Warren a link to a firm that seemed to be borrowing famous names—including Berkshire’s—to lend credibility to its activities. Warren responded that next time they would borrow “Buffett, Bernanke, and Tavakoli.”12 Warren inspires confidence, and his attitude has shifted my own. While it is true that connections bring investment opportunities to one’s door, and men have a much easier time raising money to manage than women in the gender-biased finance world, there are ways around that. Warren was an unknown in the financial world when he began, and I already have a network of contacts. Warren started out with much less money than I have in my own portfolio. In fact, not drawing attention to one’s trades is an advantage, as long as one stays out of the way of short sellers.
“Mr. Market” might be a manic depressive, but he is an equal opportunity manic depressive. The global market does not care what your name is or who you know. It does not care about ethnicity, religious affiliation, gender, or age.
Warren’s interests are not limited to the market, however. Warren has another rare skill: He is an accomplished gossip. Quality gossip is first-hand information about someone interesting, but the gossip should not be of interest to the authorities such as the Securities and Exchange Commission. It has to be known to enough people that it cannot be easily traced back to you because, if those you gossip about know you are doing it, you will be slightly embarrassed. Yet, it isn’t as if the person you are passing it along to couldn’t have found it out anyway with enough diligent digging.
Warren told me some background about a famous American family—albeit one I did not know personally—and steps they had taken for money. “But surely they didn’t need the money,” I protested in surprise. He paused and his eyes flashed with conspiratorial delight, then he nodded with a knowing smile. As fate would have it, Warren’s gossip earned extra bonus points many months later when I had dealings with the son of the famous patriarch. Now, that is great gossip.
Warren had given me much more value during this meeting than I had given him, but I did not grab the check—he had asked me to lunch. This news will dismay his detractors, who seem to have concluded that because Warren doesn’t spend his money the way they would spend it—feeding their vanity and lording it over the less fortunate—Warren must live like a miser. Yet it seems to me Warren lives a great life while being subject to the same curve balls life throws all of us. He has loyal and happy employees and investors, a loving home life, a stimulating business, and access to anyone on the planet. He has the means to take a private jet to Las Vegas for an afternoon of poker or was able to fly to the bedside of his late wife every weekend during months of chemotherapy treatments. He has created enough wealth to live well and leave a legacy that could make a lasting difference in the lives of many others. He lives his life according to what is most important to him, and he has created the means to do it. Don’t tell his detractors, they will just find someone else to complain about.
As we drove back to the office, Warren reminisced about Rosa Blumkin, whose retail furniture business Berkshire Hathaway had invested in years ago. She was a Russian Jew and evaluated people by sizing up whether or not they would hide her if it ever came to that. Trust was very important to her. I think trust is important, too, but sometimes you have to be the one willing to step up and hide someone else.Warren also mentioned that I should not neglect my love life, since that is the most important thing, as far as he is concerned. He did not discuss his personal life, other than to talk about his late wife, Susie. He was then living with his long-time companion, Astrid, whom he married on his 76th birthday.
A year after our lunch, I saw his late wife Susie in a brief clip on a Charlie Rose interview with Warren, after he had just announced that—over time—he was giving away the major part of his fortune to the Gates Foundation for charitable works.Warren sent me a CD of the original full-length interview from which the clip had been taken with a note that it captured her in depth: “After you have viewed it, I would appreciate it if you would return the copy to me.”
When I returned the copy, I sent a note:
Susie’s interview is the good news that you are loved . . . Susie struck me as a very happy woman.
Bertrand Russell described how he achieved personal happiness: “Gradually I learned to be indifferent to myself and my deficiencies; I came to center my attention increasingly upon external objects: the state of the world, various branches of knowledge, individuals for whom I felt affection.” He could have been writing about your Susie.
Although he is giving away most of his fortune, Warren has provided for his family. For years he said he would not leave them his fortune. Instead, he will leave the
m fortunate. He will provide ample funding for charitable organizations run by his children. Not only does that give them a social status and control over their lives that would be difficult to achieve in a typical corporate job, they have the opportunity to maintain self-esteem by doing important work. Warren’s wife will also want for nothing, and when one interviewer recently asked Warren to name his hero, he immediately responded:“My wife.”
When we arrived back at the office, Warren showed me a copy of his son Howard’s book of photographs capturing unforgettable faces of people living in the Third World. Warren assumed a poker face, saying, “He has really developed.” Afterwards,Warren gave me a tour of his offices and showed his gallery of letters, stopping to explain the background of some of his favorite mementos.
Warren and I met for more than four hours. By the time Warren’s assistant organized a taxi to take me to the airport, I had a lot to think about. It was time to make subtle shifts in the way I looked at my business and my personal portfolio, and from my point of view, it was well worth the trip.
As for Warren, he was doing his job. Berkshire Hathaway’s success means that Warren has billions of dollars he needs to invest, and he needs transactions of massive size. Several times during the course of the day, Warren repeated that if I found a large-sized investment opportunity in a company that meets his criteria—$1 billion or more in size—to bring it to him. He also asked me to call him.
Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street Page 4