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

by Janet M. Tavakoli

  How could one value Merrill Lynch, Lehman, or any of the other investment banks? How could anyone trust their numbers?

  Lehman announced a probable loss for second quarter 2008 of $2.8 billion, the first loss since going public in 1994. It came as no surprise when Lehman said it might boost its Level 3 assets. It raised $12 billion in new capital between February and the end of May, and said it would raise $6 billion in new equity diluting shareholder equity by 30 percent. Through sales, it reduced leverage from 31.7 times to 25 times. It sold $130 billion in assets (but it did not specify how it sold all of those assets so quickly or to whom).35

  Richard “Dick” Fuld, the 62-year-old then CEO, was a Lehman lifer. In December 1983, when Fuld was chief of trading operations, he made a presentation to Lehman’s board as it met over lunch to assess capital needs. Richard Bingham asked Fuld how he had made money in his trading operations the previous five years and how he would make it the next five. Fund responded: “I don’t know how I made it over the last five years.”36 Fuld added he had hired people “to study how we’re going to do it over the next several years.”37 An appalled Bingham asked how long that would take. Fuld responded: “Two years.”38 I wonder if Fuld completed the study.

  The SEC quickly moved to give the appearance it was on top of things. After all, we wouldn’t want another debacle like Bear Stearns, would we? The SEC said it would require Wall Street to report its liquidity levels and its capital starting later in 2008.The SEC wants disclosures “in terms that the market can readily understand . . .”39 Oh, really? About that letter the SEC sent in March. . . . That ship has sailed. After financial institutions stuff tens of billions of dollars worth of assets into a black box (Level 3 accounting buckets), how is the market supposed to readily understand? The Federal Reserve Bank, the new liquidity provider for Wall Street, seemed to have no idea of what was going on, either.The American taxpayer should ask for a refund for the money allocated to keep the SEC in operation. It makes one wonder just what it would take to get Christopher Cox booted out and have a thorough housecleaning at the SEC.

  I do not as a rule weigh in on quarterly earnings statements, but I will occasionally volunteer my views just to keep making the point. I had publicly challenged AIG’s writedowns in August 2007, Merrill’s in early October 2007, and challenged Citigroup’s reported numbers in January 2008. I told the Wall Street Journal that Citigroup might need $3.3 billion more in write-downs on its “super safe super senior” positions to reflect market prices. That would have increased Citigroup’s overall write-down due to subprime from $18 billion to $24 billion. Citigroup raised new capital that diluted shareholder equity by 10 percent. In the new world of financial topseyturveydom, diluting shareholder equity was touted as a good thing. 4041 Warren aims to preserve shareholder value.

  Oppenheimer’s bank analyst Meredith Whitney wrote a report on October 31, 2007, saying that Citigroup’s dividend exceeded its profits, saying, “it was the easiest call I ever made.”42 Since that Halloween day in 2007, Wall Street has been paying closer attention to Meredith Whitney’s reports. It seemed to take more than a month before other Wall Street analysts woke up to the problem. Bear Stearns’ bank analyst David Hilder thought her concerns were overstated. He was wrong, of course. Where did Bear Stearns find these guys?

  Citigroup’s losses continued to mount.As of October 2008, Citigroup’s subprime-related write-downs are $60.8 billion.43 Vikram Pandit had been CEO of Citigroup just over a month when the numbers I challenged were reported. Pandit cofounded Old Lane Partners in 2006 and sold it to Citigroup in July 2007 for $800 million. His personal take for his share was $165 million, but he plowed $100.3 million of it back into the fund. By June of 2008, Citigroup shut it down.The Wall Street Journal reported the fund “has been dogged by mediocre returns and the loss of its top managers.” Old Lane had raised $4 billion from investors and borrowed $5 billion more. Citigroup agreed to take $9 billion of assets onto its balance sheet after writing down $202 million. Whatever you may think of Pandit’s qualifications to lead Citigroup, it seems he knows how to time a sale.44

  Lehman was not so lucky with its sales; it could not raise cash when it need it. Many questioned Lehman’s accounting. David Einhorn of Greenlight Capital had publicly questioned Lehman’s first quarter accounting numbers. Lehman reported a $489 million “profit” and only took a $200 million gross write-down on $6.5 billion on its holdings of asset backed securities. Einhorn complained that (among other things) Lehman did not disclose its significant CDO exposure until more than 3 weeks later when Lehman filed its 10Q (a required financial report).45 In October 2008, Lehman and Tishman Speyer engineered a $22.2 billion leveraged buyout of Archstone, an apartment developer. Fortune said Dick Fuld declined to talk to it for months and it seemed to Fortune that the Archstone deal had losses almost from the start.46

  Richard Fuld tried to sell a stake in his separate asset management unit to stay afloat. He was unsuccessful. Lehman Brothers worked during the weekend of September 13 and 14 with a group of potential buyers. Bankers wanted the Fed to participate, but the Fed refused. Bankers fretted about how they would unwind (sell out) their derivatives trades with Lehman. On Monday, September 15, 2008, Lehman Brothers Holdings Inc., a 158 year-old firm, filed for bankruptcy. It is still alive in the minds of its creditors, since they will not know what they have left until Lehman’s assets are finally liquidated.4748 Hedge funds that used Lehman Brothers as their prime broker found “their” assets temporarily frozen. Like many other prime brokers, Lehman had provided financing for hedge funds to purchase assets, and now it was not clear whether Lehman or a hedge fund owned a particular asset. Like creditors, Lehman’s hedge fund customers will have to wait until the mess is sorted out. Warren had been correct in warning that the leverage unwind would be painful, and it seemed hedge funds and investment banks failed to imagine all the ways it could cause pain.

  John Thain as CEO of Merrill Lynch recognized that a Lehman bankruptcy could have negative implications for Merrill. He and Ken Lewis, Bank of America’s CEO, hammered out an agreement, and on September 14, a Sunday night, Bank of America Corp. agreed to purchase Merrill Lynch & Co. in an all-stock deal for $29 per share (at the time of the announcement worth about $50 billion), a premium to its closing price the previous Friday. The combined firm will be a behemoth if the deal closes as planned in early 2009. Bank of America will get a broader global reach; Merrill’s huge wealth management business; a huge trading operation; a prime brokerage business; and around half of Blackrock, an investment manager with $1.4 trillion under management. 49 The Fed said it did not participate in a bailout, but it expanded its lending facility just after Lehman declared bankruptcy. It would take a wider variety of securities including equities.

  In August 2008, Warren told me he read every page of Lehman’s financial report. In March of 2008, Warren told me he had been approached about helping Bear Stearns, but he could not come up with a value in a weekend (and did not have $60 billion in capital). He expanded on that to the students from the University of Pennsylvania when he said that bailing out Bear Stearns “took some guts that I didn’t want to match.”50 The balance sheets of the investment banks are so difficult to figure out that one cannot tell whether one is getting a good deal.

  Pimco’s Bill Gross found there is a limit to the Fed’s largesse, and his Lehman investment lost money. In March, Bear Stearns, the fifth largest investment bank, was deemed too big to fail, but the Fed refused to help Lehman, the fourth largest investment bank. As Jim Rogers predicted, larger investment banks than Bear Stearns had problems, and the Fed had other problems besides investment banks—Fannie, Freddie, and AIG. Pimco’s investments were only partially protected by the Fed. The Total Return Fund’s return slumped, and it will be interesting to see if Gross ends up a net winner or a net loser as the market struggles for balance.

  Jamie Dimon, JPMorgan Chase’s CEO, bought Bear Stearns, and Ken Lewis, Bank of America’s CEO, bought Merr
ill Lynch. Did either of them get a good deal? Did both of them get good deals? Who got the better deal? Ken Lewis certainly passed up Jamie Dimon in size, but only time will tell how this plays out. For my part, it seems that Ken Lewis is the more underestimated of the two.

  In May 2003, I heard both CEOs give luncheon speeches at the Federal Reserve’s Conference on Bank Structure and Supervision. Jamie spoke the day before Ken Lewis. Jamie dressed in a light suit and spoke rapidly, sounding as if he had just drunk a pot of coffee. He seemed to suggest he had solved all of the problems at Bank One in the vein of a public relations speech (this predated its merger with JPMorgan Chase). He seemed uncomfortable with silence. In between questions the microphone was passed around for a few seconds. Jamie added to his already complete answers, and it seemed an attempt to fill dead air. The next day Ken Lewis spoke. He wore a conservative dark blue suit with a flag pin in his lapel. His grooming was impeccable. His speech flowed. Unlike Jamie, he spoke about corporate governance, the topic at hand. He gave clear and balanced reasons why (contrary to popular wisdom) it made sense in Bank of America’s case for him to occupy the position of both chairman and CEO. Ken Lewis left me with the impression that he is a very ambitious man who comes prepared. He did not underestimate his audience.

  Perhaps these CEOs have a better crystal ball than Warren Buffett and I.The list of accounting distortions seems endless, 515253 but the key is to understand business fundamentals first, and then consider what the accounting statements imply.

  By October 2008, J.P. Morgan acquired Bear Stearns and Washington Mutual; BofA acquired Merrill; and Wells Fargo acquired Wachovia. Morgan Stanley and Goldman Sachs became bank holding companies. The Treasury invested tens of billions of dollars in each. AIG got a bailout. Lehman was bankrupt. The situation is fluid. Meanwhile, Berkshire Hathaway has limited debt (leverage) and a lot of cash.

  Starting around 1980, Berkshire Hathaway’s nonreported (undistributed) earnings from the ownership of equities exceeded reporting earnings generated by the business it owns.That means there is a lot of hidden value that does not show up on accounting statements. Earnings and return on equity are important measures, but the intrinsic value of the company is the key.

  Today, investors can purchase low-fee index funds, so a reasonable benchmark is the S&P 500. Each year, Berkshire Hathaway compares its performance with the S&P 500.Warren Buffett and Charlie Munger strive to increase intrinsic value, the true value including value that is obscured by accounting statements. They say that if they cannot beat the S&P that way, then they are not doing anything an investor cannot do on his or her own.

  So far long-term Berkshire Hathaway investors, including me, have been delighted. No one can predict future performance, but long-term investors continue to hold their stock. Not only does Berkshire Hathaway invest in stocks and pieces of companies, many of the companies owned by Berkshire Hathaway also invest. If Berkshire Hathaway owns less than 20 percent (accounting rules are subject to change, so this percentage is just an example) of a company, it does not have to include (consolidate) the company’s earnings on Berkshire Hathaway’s balance sheet, even when this represents a huge wealth increase.

  In 1990,Berkshire Hathaway owned 17 percent of Capital Cities/ABC, Inc. (Capital Cities). Berkshire Hathaway’s share of Capital Cities earnings was $83 million, but Capital Cities retained more than $82 million (of Berkshire Hathaway’s earnings) for future growth. Berkshire Hathaway only got about $530,000 net after-tax dividends. According to generally accepted accounting principle (GAAP), Berkshire Hathaway only had to record the dividends as earnings, so it recorded $530,000 (not $83 million). If Capital Cities/ABC, Inc. sounds unfamiliar to you that may be because Disney bought it in 199554 Berkshire Hathaway sold its holdings in Disney a few years after the takeover. Warren’s favorite holding period may be forever, but that does not mean he will hold something he no longer favors forever.

  Berkshire Hathaway prefers to purchase companies that generate earnings that do not have to be reported. If Berkshire Hathaway buys an entire business, Berkshire Hathaway must report the earnings. Sometimes, however, Berkshire Hathaway can acquire a minority interest in a company more cheaply (on a pro rata basis) than it would have paid for the entire company. Furthermore, Berkshire Hathaway does not have to report the earnings for the minority interest. The price is a relative bargain, and the unreported earnings should eventually become capital gains. In turn, the capital gains will increase Berkshire Hathaway’s intrinsic value.

  When Berkshire Hathaway acquires a company or part of a company, it looks for good managers. If the stock price falls below the value of the business the managers should buy back the stock. If the price is above the business value, however, managers will either (1) retain earnings if they can increase market value by a dollar for every dollar of earnings they retain; or (2) if they cannot do that, they should pay dividends. Good managers know these finance basics and follow them.

  Accounting also misleads when it comes to the stock price that is recorded on the books (the carrying price). Berkshire Hathaway’s subsidiaries may carry value at one price, while Berkshire Hathaway itself carries the same stock on its book at another price. Again, that is legal and proper accounting.

  Highly leveraged investment banks stuff tens of billions of dollars worth of assets into black boxes (Level 3 accounting) and use other method to avoid showing market prices for assets (hold-to-maturity portfolios).The investment banks may have hidden problems. Investment banks may be worth less than their accounting reports suggest. In contrast, Berkshire Hathaway has hidden value. Berkshire Hathaway does not report retained earnings or capital gains on long-term investments unless the investments are sold.

  Berkshire Hathaway reports fluctuations in market prices of its derivatives, however. Berkshire Hathaway took a loss on derivatives in 2007 and in first quarter 2008. Berkshire Hathaway’s invested $4.88 billion in premiums (up from $4.5 billion at the end of 2007) for puts it wrote on equity indexes, and the first payment—in the unlikely event one ever comes due—is 2019. Berkshire Hathaway took a mark-to-market loss it can afford, a write-down of $1.7 billion in the first quarter of 2008. Magen Marcus, a medical doctor who has been a Berkshire Hathaway shareholder for five years, called them “unrealized losses.”55 He is an informed shareholder. In his 2007 shareholder letter, Warren told us that he and Charlie Munger are not concerned about the price fluctuations: “even though they could easily amount to $1 billion or more in a quarter—and we hope you won’t be either.”56 They are willing to cope with reported earnings volatility “in the short run for greater gains in net worth in the long run.”57

  Berkshire Hathaway does not chase revenues for the sake of revenues; the price must be right. When rating agencies suggested that Berkshire Hathaway should increase insurance revenues to maintain its AAA rating, Warren told me he rejected their premise. Berkshire Hathaway is happy to do nothing when the risk is not priced correctly, but many insurance companies did not feel the same way. This critical difference led to an opportunity for Warren Buffett he never sought. An insurance regulator knocked on Berkshire Hathaway’s door when it needed help.

  Chapter 11

  Bond Insurance Burns Main Street

  You have been writing some terrific stuff. I send it along to Ajit and he’s now a big fan.

  —Warren Buffett

  to Janet Tavakoli, January 3, 2008

  When he was in his twenties,Warren Buffett put three-quarters of his money (around $10,000) into property and casualty insurer GEICO, and reaped a healthy profit. Since then, he has been keenly interested in insurance opportunities. The credit crisis dropped an opportunity in Berkshire Hathaway’s lap.

  As Bear Stearns and the Carlyle fund struggled for their survival on March 12, 2008, news about bond insurance was not a highlight, but it should have been. In what would become an ugly pattern, one of the bond insurers that had been AAA at the start of 2008 was downgraded several grades (by Fitch), and it filed
a lawsuit in an attempt to nullify a nearly $2 billion guaranty.1

  Bond insurers traditionally provided credit enhancement for municipal bonds needed to fund roads, schools, water treatment plants, and many other necessary public works. Now bond insurers are an integral part of the credit bubble problem. Most of the bond insurers (or monolines2) have exposure to subprime home equity loans or troubled loans bundled in risky securitizations. Most bond insurers have done dicey deals dirt cheap. Most of them need more money. It is as if they offered hurricane insurance on homes and insured everyone in Florida without enough money to cover potential obligations. Instead of insuring homes, the insurers were insuring bonds without enough money to cover the potential obligations or to keep their AAA ratings. Their folly affects the average American taxpayer and many retail accounts.

  Bond insurers provide guarantees for municipal bonds, which often have very long maturities. The interest rate is set at periodic auctions, and these auction-rate securities (ARS) were sold as if they have been like a cash instrument or a money market instrument.The same day in March 2007 when the bond insurer filed its lawsuit, I was in New York. I met with the CEO of a large foreign manufacturing company. He told me he was suing the investment bank that sold his cash manager more than $10 million in auction-rate municipal bonds guaranteed by a bond insurer. “[The investment bank] told him it is the same as cash.” By February 2008, around 70 percent of the $330 billion auction-rate securities market for municipalities, student loans, and colleges failed when investment banks and banks stopped bidding for the “insured” bonds that investors wanted to sell (or did not want to buy).