Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street

by Janet M. Tavakoli

  When Dimon testified before Congress, he might have used more balanced candor about Bear Stearns. Specifically, it might have been better for the financial system to let Bear Stearns fail. Within two months JPMorgan revised its estimates of merger-related costs 50 percent upward to $9 billion. Richard “Dick” Bove of Laden Burg Thalmann & Co. said that Bear Stearns would not add to JPMorgan’s profits and Bear “should have gone bankrupt,” noting it has a nice office building in Manhattan—”big deal.”58

  On June 16, 2008, JPMorgan stated that Bear Stearns is worth more than the $10 per share it paid.59 But financial firms can trade at single digits during recessions. Salomon Brothers had a saying: “Our assets ride down the elevator at night,” meaning the people that generate the fees, make the trades, and attract the customers. Bear Stearns lost customers (in addition to employees). Given the opacity of investment banking products, there is no reason to accept JPMorgan’s claim at face value. Suppose it were true that Bear Stearns was worth more than $10 per share (and I can fly).That is all the more reason the Fed should not bail out an investment bank. In bankruptcy, everyone has a chance to bid on the assets and the net result may net shareholders more.

  If, however, Bear Stearns’ stock was worth zero, it still doesn’t make sense to bail it out. Bear Stearns would go into bankruptcy and JPMorgan Chase could have cherry picked the assets and paid less. If Dimon were after Bear Stearns’ employees, they would have been ripe for hire.

  I find my theories more plausible than the Apocalypse Now story the Fed told to Congress, but now we will never know.

  Was Warren Buffett even tempted by Bear Stearns? I do not know for certain, but I have a point of view. On September 27, 2007, BusinessWeek’s Matt Goldstein asked me if I had seen a New York Times article suggesting that Warren Buffett was considering the purchase of a stake in Bear Stearns. The original article stated that “Mr. Buffett did not return telephone calls seeking a comment.”60 It did not surprise me; it is hard to talk and laugh at the same time. Goldstein was not suggesting I had a particular reason to know, it was just that everyone was talking about it. Many news outlets picked up the viral rumor and CNBC aired at least five segments that day on the rumor that Buffett was a potential buyer.61

  I told Goldstein that I had no way of knowing for sure, but heck no.

  Chapter 10

  Bazooka Hank and Dread Reckoning (AIG, Fannie, Freddie, Lehman, Merrill, and Other F luid Situations)

  If they sell five percent of it, they’ll get the market price.

  —Warren Buffett

  to Janet Tavakoli, August 10, 2007

  Before the fall of 2007, few besides Warren Buffett, John Paulson (Paulson & Co.), Bill Ackman (Pershing Square), David Einhorn (Greenlight Capital), Jim Rogers (Rogers Holdings), and I specifically challenged investment banks’ prices of complex structured products. On August 9, 2007, I told CNBC that “when you get truthiness in lending you get truthiness in pricing.” Even with corporate leveraged loans, there is “too much foam and too little beer.”1 Many AAA rated money market investments were losing money because they were backed by CDOs backed by subprime loans. Becky Quick of CNBC asked who is vulnerable, and I responded just about every investor: hedge funds, REITs, insurance company investment portfolios, mutual funds, and money market funds might lose money.

  The next day, I challenged American International Group Inc.’s (AIG) accounting, after it told analysts it did not need to show a loss (reflecting a change in market prices) on its credit derivatives portfolio for its second quarter ending June 30, 2007.Yet, accounting practices required AIG to mark to market its portfolio using market prices or a close approximation to market prices.The rule did not say only if you feel like it. AIG seemed to take the position that (1) nothing like this is currently trading, so there is no market price; and (2) AIG would never have to make any cash payments because its portfolio was so “safe.” Accounting gives one a lot of room to make reasonable assumptions, but how could AIG say nothing had changed?

  For example, AIG wrote credit default protection on a whopping $19.2 billion “safe” investment that had exposure to subprime loans (a super-senior tranche of a CDO backed by BBB rated tranches—the lowest rating that is still investment grade—of residential mortgage-backed securities, and these were backed by a significant amount of subprime loans. By August 2007, the prices of the collateral backing the super senior had tanked.)2 Anyone who buys insurance knows that even if you are “safe,” if you are in a high-risk category, your cost of insurance goes up. If AIG were to pay someone to take over its insurance-like obligation, AIG would have to pay more than it had received, and AIG should have shown this as a loss.

  AIG’s stance seemed bizarre given that five insurance executives from AIG and Berkshire Hathaway’s Gen Re Corp (even Warren Buffett cannot control every action of every employee) were under investigation (and eventually found guilty) of conspiracy to inflate AIG’s reserves and mislead investors about AIG’s earnings.3

  I told Dave Reilly at the Wall Street Journal: “There’s no way these aren’t showing a loss.”4 That is simply a market reality. This is Wall Street speak for: In my humble opinion, you are a big fat liar. AIG responded: “We disagree.”5 That is Wall Street speak for: No,YOU are a big fat liar!

  Before Dave Reilly wrote his article, he talked to experts, including me, for background. Then he called AIG to ask them for their thinking. AIG stood firm. Then Reilly called me again. He didn’t want the Wall Street Journal to look stupid, but told me, “they pay me to go out on a limb.” He said he needed me to go on the record. It would make the article more forceful. I did not think that AIG would tell Reilly: You know, you have a point, maybe we should recheck our homework, but I did not anticipate arguing with AIG in the Wall Street Journal’s “Heard on the Street” column. I hesitated. AIG, a large global conglomerate, has the resources to crush me like a bug. On the other hand, I am not fat. I finally agreed to go on the record.

  By June 2008, AIG recorded two back-to-back quarters of its largest losses ever. AIG took more than $20 billion in write-downs on its derivative positions through the first quarter of 2008; net losses for the fourth quarter of 2007 were $5.3 billion, and in the first quarter of 2008, AIG reported losses of $7.8 billion. In February 2008, its auditor said it found “material weakness”6 in AIG’s accounting. Eli Broad, a billionaire real estate baron, Shelby Davis of Davis Selected Advisers LP, and Bill Miller of Legg Mason Inc., were AIG shareholders controlling 4 percent of the company (more than 100 million shares). These already accomplished men may have a hidden talent. Apparently, they can read my mind. These shareholders wanted changes in senior management and a new CEO, and they wrote AIG’s board: “The facts presented . . . preclude any individual who was in a position of significant responsibility and oversight during the last three years from having the credibility to lead this company on a permanent basis.”7 That is shareholder speak for: We are not calling those responsible for oversight big fat liars, we are just saying they have no credibility.

  By the summer of 2008, more than nine months after the August 2007 Wall Street Journal story, the Slumbering Esquire’s Club (also known as the SEC) and the Department of Justice were investigating whether AIG had overstated the value of its credit derivatives exposure to subprime mortgages.8 In the summer of 2007, the SEC might have questioned everyone’s accounting. Well, not everyone’s—just several large investment banks and various other entities that the SEC regulates.

  Likewise, OFHEO, then regulator of Freddie Mac could have questioned Freddie’s accounting. In 2004, David A. Andrukonis, then chief risk officer for Freddie Mac, was concerned about Freddie’s purchases of bad mortgage loans. He told then CEO Richard Syron that the loans would probably “pose an enormous financial and reputational risk to the company and the country.”9 While taking on more risk was bad enough, the Department of Treasury reviewed Freddie’s books in preparation for a bailout and concluded in September 2008 that its capital cushion had b
een overstated by Freddie Mac’s accounting methods.10

  On July 15, 2008, ex-Goldman Sachs banker and then Treasury Secretary Henry (“Hank”) Paulson asked Congress for the authority to buy stakes in Fannie Mae and Freddie Mac. Paulson asserted: “If you have a bazooka in your pocket, and people know you have a bazooka, you may never have to take it out.”11 In my experience, boasting about a big bazooka just tempts the curious to see how you measure up in exciting circumstances, and the person to do that might be named Mr. Gross. Bill Gross manages the Pimco Total Return Fund, the world’s largest bond fund with large exposures to Fannie Mae and Freddie Mac (and AIG along with a number of investment banks as of September 2008). Gross is a fan of Fed intervention, and his investments reflected it. His fund reportedly gained $1.7 billion after the U.S. government took over Fannie Mae and Freddie Mac on Sept 7, 2008.12 Fannie Mae and Freddie Mac were placed in conservatorship to be run by their new regulator, the Federal Housing Finance Agency (FHFA) headed by James Lockhart, the same gentleman that headed up their former regulator, OFHEO. What was the thinking on choosing Mr. Lockhart—let’s give him another chance, because he cannot possibly do a worse job than he did before? The Treasury may purchase up to $200 billion of stock, dividends were suspended (long overdue in my opinion), and the CEOs were replaced. Both Fannie Mae and Freddie Mac were removed from the S&P 500 on September 9.13 Herb Allison, a former CEO of TIAA-CREF, will head Fannie Mae. David Moffett, retired vice chairman and chief financial officer of U.S. Bancorp, became the CEO of Freddie Mac. Mr. Moffett was most recently a senior advisor to the Carlyle Group.1415 Business as usual in Washington.

  In September 2008, AIG’s problems grew worse. One of the reasons AIG may have initially resisted showing losses on its credit derivatives positions is that price declines triggered a need for more cash to meet collateral calls from AIG’s trading counterparties. Warren was right. Credit derivatives are weapons of mass liquidity destruction. By the end of July 31, 2008, the company that refuted my August 2007 assertion that it had risk from credit derivatives, had already put up $16.5 billion in collateral. To paraphrase Warren, AIG sucked its thumb in 2007. AIG was in the midst strategic review and had set its deadline at September 25, 2008.16 The Fed took over AIG on September 15.

  Moody’s rated AIG Aa2 at the beginning of May 2008, and downgraded it to Aa3, the lowest double-A rating, on May 22, 2008. In early September 2008, AIG’s rating neared single-A territory. AIG had lived in denial for more than a year. It had failed to sell assets to raise the cash it needed to face additional margin calls (triggered by the downgrade) of $14.5 billion. AIG has valuable assets, but the assets are illiquid and AIG was short of cash. On September 15, 2008, AIG was downgraded to single-A. AIG asked the Fed for a loan. When the Fed resisted, it sought a $75 billion loan from Goldman Sachs and JPMorgan Chase.17 No dice.

  Goldman Sachs said its exposure to AIG is not material.18 Of course, it wouldn’t be if Goldman’s trades have collateral triggers (or if it bought credit default swap protection on AIG). A better question is, what is the combined trading, insurance and reinsurance exposure of Bazooka Hank’s old firm if AIG did not have to pony up so much of its cash and if Goldman had no default protection on AIG? Is it material? JPMorgan is one of the largest credit derivatives traders in the world, and with its acquisition of Bear Stearns, it was probably the largest. AIG sold credit default protection on $441 billion of assets to a number of European and U.S. counterparties. If AIG could not make good on its promises, it would affect the entire financial community.19 The technical term for this is systemic risk. In this case it is the result of global financial institutions doing foolish things at the same time.

  The Fed changed its mind and decided to give AIG the loan after all. Although the Fed never regulated AIG, it agreed to provide AIG with a $85 billion credit line for two years (similar to a credit card with an $85 billion limit - wouldn’t you just love one of those?) in exchange for interest payments and stock warrants (the right to buy, under certain conditions, up to 79.9 percent of AIG). The Fed will end up controlling a private insurer with the help of U.S. taxpayer dollars.20 What gave the Fed the right to do that? It invoked an obscure rule under section 13(3) of the Federal Reserve Act with the full support of Bazooka Hank’s Treasury Department, just as it did when it helped JPMorgan Chase purchase Bear Stearns.21 The new Wall Street speak for institutions like AIG that have illiquidity problems requiring intervention is that the “situation is fluid.” It remains to be seen how successful the Fed will be in stabilizing and making a profit (or loss) from AIG.

  Bill Gross’s Pimco Total Return Fund had sold $760 million of default guarantees (as credit default swaps) on AIG, and it would have cost him if AIG went under.22 Mr. Gross might have thought he had a good idea of how the Fed would behave. Pimco had hired Alan Greenspan as a consultant.23 I was not surprised when Bill Gross said the Fed intervention was a “necessary step.”24

  AIG seemed to have lost the plot on its cash needs, especially those linked to CDOs. In April of 2008,Warren told a group of University of Pennsylvania students that when it comes to CDOs, “Nobody knows what the hell they’re doing. It’s ridiculous.”25

  Accountants do not seem to know what they are doing, either.

  Accountants allow corporations to put assets into three “levels.” The “level” indicates how easy it is for someone to check your work, with Level 1 being the easiest. Level 2 requires you to accept assumptions that you can supposedly recreate with enough hard work and data. Do you have several hundred thousand dollars and an army of geeks? Level 3 requires you to trust management assumptions that you cannot see and they do not disclose—it is reminiscent of teenage boys at their first prom: trust me, I will love you in the morning.

  Level 1 is mark-to-market-based on observable market prices. For example, if you own stocks, you can find the prices very easily online. It is easy to calculate the value of your stocks every day. This is what accountants mean by mark-to-market. Since it is easy to do and anyone can check your work, it is transparent.

  Level 2 is mark to model. Prices are based on models using observable assumptions. Accounting gives you some room to make assumptions. You cannot easily find prices in the market on many CDOs.You can debate mark-to-model prices. For instance, the creditors of BSAM challenged the April 2007 prices of the two hedge funds. Since management can control the assumptions, even with “observable” inputs, Level 2 can be “mark to myth.”

  Level 3 accounting allows management to come up with prices based on models using unobservable inputs. In the absence of any other disclosure, I consider Level 3 purely mark to myth. It is a black box. You have no evidence that management is leveling with you.

  Benjamin Graham put it another way. The formulas may be precise, but the assumptions may be self-serving and can be used “to justify practically any value .. however high.”26

  FASB board member Donald Young says that mark-to-market accounting is “most valuable”27 when markets are tough. If prices decline, it signals investors that assets are under stress. If managers make up their own estimates instead of marking-to-market, it can be “mark-to-management”28 or as Warren Buffett says again, it can be “mark to myth.”29 If companies think prices will recover in future, they can explain it in their regular reports (the regulatory filings with the SEC).

  In August 2007, Warren told me that if financial institutions sell 5 percent of their position, they will get the market price, and it will still be a higher price than they would get if they tried to sell 100 percent of a large illiquid position. He laughed as he added: “No one wants to do that.” In September 2007, Fortune reported that some financial institutions might appear healthy, but leveraged institutions might actually be insolvent if they marked-to-market instead of marked to model. “Many institutions,” Warren said, “that publicly report precise market values for their holdings or [sic] CDOs are in truth reporting fiction,” adding “I’d give a lot to mark my weight to ‘model’ rather than t
o ‘market. ’”30 Warren explained that selling 5 percent of their positions would reflect reality. I wrote Warren that I call this Warren Buffett’s Five Percent Solution. He wrote back: “In the print edition of Fortune they changed “of ” to “or” in the first sentence, though I got it corrected online.” I responded: “I am usually fast and accurate, but rarely impeccable and precise.” He sets a high bar.

  The SEC seemed to have another idea. The last weekend in March 2008 (a couple of weeks after the Fed said it would exchange AAA assets for Treasuries), the SEC’s Division of Corporate Finance issued a letter that could have been called Retroactive Amnesty for Potential Alleged Accounting Fraud. The letter concerned public companies and disclosure issues they “may wish to consider”31 when preparing their regulatory filings. It said that under current (tough) market conditions, public companies might be required to use models with “significant unobservable inputs”32 So, as of January 1, 2008, the companies could put those assets in a black box (Level 3).

  The SEC appeared to override the accounting board. Since when does the SEC interpret accounting rules that contradict public pronouncements by FASB? Yet the SEC seemed to encourage investment banks to classify more assets as “Level 3.” Classify they did. For example, in early May 2008, Goldman Sachs Group Inc. announced that for its fiscal quarter ending in February, it increased its Level 3 assets by 39 percent or by more than $27 billion. It had $96.4 billion in assets sitting in its Level 3 accounting bucket. Morgan Stanley had $78.2 billion in assets sitting in its Level 3 accounting bucket. Merrill Lynch announced that its mark-to-myth assets increased from $48.6 billion at the end of 2007 to $82.4 billion for the first quarter ending March 31, 2008 (Merrill is on a different fiscal calendar), an increase of 70 percent.33 The list goes on. Merrill Lynch’s new CEO, John Thain, brought in 51-year-old Tom Montag from his old Goldman Sachs stomping grounds to head up global trading for around $40 million.34 Wouldn’t you think that for that kind of money, Merrill could disclose their assumptions?