Warren has repeatedly said he wants to do “premium business at premium prices,”27 and he insures risks he can understand. Stempel could not reach Ajit Jain or Berkshire for comment, but I had already told this much: “I would be surprised if he were to touch the financial guarantors’ [bond insurers’] structured products, given that the underwriting standards seemed so poor.”28
After the municipal bond market auction failed in the second week of February 2008,2930 Warren Buffett’s Berkshire Hathaway Assurance reinsured $50 million of bonds and was paid a 2 percent premium, double the original 1 percent premium for primary insurance from the bond insurers. Put another way, Berkshire Hathaway Assurance received two times the original premium to back up the existing insurance, in case the insurer cannot pay.31 By the end of February Berkshire Hathaway Assurance did 206 transactions and was paid an average of 3.5 percent on business that the primary insurer originally underwrote at 1.5 percent.32
Warren is happy to do zero business when risk premiums make no sense. Berkshire Hathaway’s triple-A rating is trusted as a genuine rating. Its stated intention of doing premium business at premium prices may leave the largest of the legacy bond insurers scrambling for scraps.
Chapter 12
Money, Money, Money (Warren and Washington)
That’s the problem . . . you can’t regulate it anymore.You can’t get the genie back in the bottle.
—Warren Buffett
(in Reuters), May 24, 2008
In the spring of 2008, both Warren and I said the United States was already in a recession. In May 2008,Warren told CNBC that “it will be deeper and last longer than many think.”1 Yet many economists sound like the Merchants of Death (MOD squad) in Thank You for Smoking : “Although we are constantly exploring the slowdown, there is currently no economic evidence to suggest the economy is in a recession.” The classic definition of a recession calls for two consecutive quarters of negative growth, and as of the summer of 2008, the numbers did not yet show it. Election years bring out the best in the economy. In the long run, we need to improve productivity and spend less—I will get to that later. In the short run,Warren is right.The United States is in a recession combined with inflation and low growth, a condition called stagflation.
How did this happen? For most of this century, Washington has pumped money into the economy by keeping interest rates low. Easy money tempts crooks. Speculators and fraudsters had a party. Regulators became enablers. Cheap money fueled bad lending, including predatory lending, and cheap money expanded the housing bubble.There are genuine victims of predatory lending.The war on poverty became a war on the poor. Those victims face crushing debt, a weaker dollar, and rising prices. Now even the average American is the victim of bad policies combined with widespread financial crime. Most Americans feel the negative wealth effect of rising prices, falling home values, and tighter credit. Consumers cut back on spending while struggling with higher food and gas prices. Bailouts of poorly regulated investment banks and corrupt mortgage lenders mean Washington is printing more money, which weakens the dollar. Inflation adds to the misery. Americans feel poorer.The United States is in a recession combined with stagflation.
Washington is supposed to provide a strong national defense; but we were attacked from within our own borders—sometimes by those charged to protect us. Washington failed in one of its most important duties.Washington failed to protect our money.
What is money? Money is a store of value. It does not matter whether we talk about gold coins, silver, diamonds, bearer bonds, pieces of paper with pictures of dead presidents, salt, cacao, tulip bulbs, or a signed check. We accept these things as money, because we have a common agreement (or hallucination) of their value.
Our idea of value changes as circumstances change. If crops fail and I am starving, I’d prefer to stockpile wheat rather than gold. If you have no wheat, I would prefer to have gold than take your credit, since it will be easier for me to convert gold into food than to convert your credit into food. We invented money to enhance our probability of survival. The best money is an abundant store of value measured in a standard and reliable manner. When anyone—especially someone we elected to a position of authority—messes around with the value of money, we should all take it very seriously. Homeland security requires a secure homeland currency.
There are three basic kinds of money. The first is commodity money, something usable that humans value. Children quickly grasp the concept of commodity money the first time they swap toys. Commodity money is gold, silver, rice, wheat, oil, salt, or any number of usable goods. Beads went out of fashion as currency in the United States soon after Europeans used them to purchase Manhattan from Native Americans. Gold is still in fashion because the global community agrees it has value. The gold standard was dissolved in 1971, but before that, Europe relied on it both officially and unofficially for about 900 years. Central banks still stockpile physical gold. Gold is still considered a benchmark, even though it is no longer the standard.
Warren invests in businesses that make things that people use and that are unlikely to go out of fashion (for a long time). For example, people enjoy eating Dairy Queen’s ice cream treats, and human taste buds are unlikely to evolve to new preferences in our lifetime.
Credit is the second kind of money. Most of us have checking accounts. People who accept our checks assume our credit is good enough that the check will clear. Our assets in the form of checking deposits back our check, and the currency in our checking account will keep its value long enough to have the same purchasing power when the check clears. If there is hyperinflation, merchants will not accept checks. Credit has been around since humans shared food with the expectation that they would benefit from a future meal—an asset—provided by their fellow tribesmen. Shipping merchants have used trade receivables for centuries using credit against a shipment of saleable goods.This only worked, because everyone expected your “ship to come in.” International banking was born, because we wanted to trade goods between distant lands.
Warren and Charlie Munger avoid leverage, because it makes it much easier for people to trust that Berkshire Hathaway will always meet its obligations and keep its genuine AAA rating. Furthermore, since its businesses are throwing off so much cash, Berkshire Hathaway’s ship is always coming in. Berkshire Hathaway’s businesses throw off cash of around $100 million per week. It has no problem meeting obligations. Its problem is finding more good businesses in which to invest all of this money.
The third kind of money is fiat money (this is not money to buy a designer car, as many young Wall Street bankers seem to think), such as the pieces of paper your government prints and issues as its currency notes. Fiat money is not backed by a commodity. Fiat money is not backed by assets (unlike a check which is backed by checking deposits). The faith and credit of a government back fiat money.The world relied on commodities such as gold until we formed the nation-states. Until then, we did not trust each other’s coins and printed papers. Until the beginning of the twenty-first century, hard currencies, defined as reliable currencies, included the U.S. dollar, Swiss franc, pound sterling, Deutsche mark (now replaced by the euro), and Japanese yen. The Deutsche mark (before the euro) and dollar held premier positions as reliable global currencies. By 2008, the dollar’s reliability as a store of value lost credibility as the world looks askance at the United States’ inconsistent policies and disastrous dollar diluting actions. China’s currency, the renmimbi, is gaining credibility. Some consider it an emerging hard currency, but that remains to be seen. When it comes to money, government matters. If you live in a Third-World country and your government is run by corrupt thugs who loot the treasury and destroy the local economy, your country’s fiat money will be nearly worthless to the international community. It is a lot harder to shake down a currency like the United States dollar. The United States is still a rich country, so a little corruption will not destroy the currency. But a lot of corruption combined with making promises for which we
cannot pay (a $9 trillion national debt) and lower productivity are destroying faith in the U.S. dollar. Lately, the United States policymakers have demonstrated a twisted genius for causing the dollar to lose value.
In finance, credibility is extremely important. Warren Buffett and Charlie Munger educate Berkshire Hathaway’s 40,000 odd shareholders so that they understand that Berkshire Hathaway’s AAA rating is solid.The entire financial community trusts it.Washington should have worked hard to make sure the dollar kept its credibility in the global financial markets.
The dollar is weakening partly because of growing U.S. current account deficit. The United States used to produce more than it consumes, and the rest of the world owed us. We reached a turning point in 2006 and headed in the wrong direction. We started consuming more than we produce. We now shovel $2 billion per day out the door and into the pockets of the rest of the world. It is as if we have a large lot of land and are selling off the fringes of our gardens so we can buy more consumable goods for the house.We are transferring a part of the ownership of our country abroad. For the first time in about 100 years, we are relying on credit with the rest of the world and have become a net seller of our assets to subsidize our spending habits. The current generation is spending and building up a large debt. How will your children and grandchildren feel if after you die they have to spend part of their time working to pay off tens of thousands of dollars of credit card debt you left behind? While the debt we are taking on is not credit card debt, our children and grandchildren will have to pay it off if we do not come up with a better solution soon.The solution is to start producing more than we consume, and it will not be easy. America is aging, and the number of workers is declining.
Washington has created a $9 trillion gross national debt. The size of the debt is around 80 percent of the $11.5 trillion U.S. residential mortgage market, or about $38,000 for each citizen of the United States (counting children and those no longer working). The only way to reverse this course is to increase national productivity relative to spending, practice sound lending (especially for the housing market), stop bailing out those responsible for this mess, and force the bloated regulatory system to go on a diet and do its job. American ingenuity and innovation may create future productivity gains, but we cannot depend solely on that.
Since we are so wealthy and since our lifestyles will improve with the debt we are accumulating, it is easy to avoid thinking about the fact that we will eventually get to a point where the amount of debt is uncomfortable.Then things will slide.That will be decades away, and our children will suffer the effects of our foolishness. Our enormous debt is growing slowly, but it is growing. Meanwhile the dollar is weakening.
There is a high cost of doing nothing. Around 100 years ago, Britain was the world’s greatest power, generating vast wealth from its sprawling empire. Britain is currently in no danger of becoming a Third-World country, but at times it seems like a very strong “Second-World” country. For all of the vast resources of the United States, in 50 to 100 years, we will become tomorrow’s Britain. After I commented on these problems in an interview with Harlan Levy of Connecticut’s Journal Inquirer in the fall of 2007, Warren wrote me: “Your answers in the interview . . . are 100 percent on the mark. Congratulations.”
Warren’s late mentor, Benjamin Graham, said it requires “considerable will power to keep from following the crowd.”2 In finance, following a bad crowd can lead to enormous financial gain (in the short term), so bankers can be tempted to take the easy road to riches instead of the high road. Sadly, regulators themselves sometimes succumb to temptation, and it is particularly vexing when it causes us to lose a strong advocate of investors’ interests. Washington failed to regulate Wall Street, failed to regulate mortgage lenders, and regulators failed to regulate themselves.
On Valentine’s Day 2008, the Washington Post printed New York Governor Eliot Spitzer’s screed on the Bush administration’s enabling role in the subprime lending crisis. The former New York attorney general’s aggressive prosecution of malfeasance relating to the dot com and Enron scandals had earned him the nickname the “sheriff of Wall Street.” His article castigated the Office of the Comptroller of the Currency, the national bank examiner, for its 2003 actions that protected national banks and predatory lenders from states’ lending laws. Spitzer did not stop there. He labeled the Bush administration a “willing accomplice” of unfair lending. He wrote that the administration thwarted state attorneys general with “an aggressive and unprecedented campaign to prevent states from protecting their residents . . . ” from predatory lenders.3 Aggressive in his methods, arrogant in demeanor, ruthless when exercising “prosecutorial discretion,” Eliot Spitzer’s often excessive zeal was excused by the media because he directed most of his energy at financial malfeasance. Spitzer may have imagined himself the arbiter of moral high ground, but he was no Thomas Moore.
On March 10, 2008, the New York Times broke the Spitzer scandal. More than one financier protested to me that in Europe, Spitzer’s escapades would not even be a crime. Unfortunately for Mr. Spitzer, the news did not break in Amsterdam, it broke in New Amsterdam. Spitzer neutered himself. In his previous role as attorney general of New York, he oversaw the organized crime task force that prosecuted prostitution rings. By Spitzer’s own standards, he was done. On the day Spitzer’s article appeared in the Washington Post, the then-governor of New York and alleged Client 9 of the Emperor’s Club VIP, gave his many enemies the ammunition they sought. He allegedly met with call girl “Kristin” in room 871 of Washington’s Mayflower Hotel and paid her $4,300. The post-911 Patriot Act, legislation allowed authorities to track Spitzer’s legal money transfers and record cell phone conversations referring to the alleged illegal prostitution transaction. The Bush administration could not capture Osama Bin Laden, but it got “Sheriff ” Spitzer.4
His downfall is a tragedy for those trying to balance the scales of justice in the financial markets and a cause for snide soaked relief among the many targets of his investigations. Yet, for Spitzer himself, there is little pity; he engineered his own political suicide by cop. Spitzer announced his resignation as governor of New York on March 12, effective at noon on March 17, 2008. News of his disgrace broke just in time for the Fed to announce its $200 billion liquidity bailout that for the first time extended directly to investment banks and indirectly to private equity funds and hedge funds. His resignation occurred the same day the JPMorgan Chase announced its Federal Reserve and Treasury orchestrated purchase of Bear Stearns.56
Among other issues with the Fed actions, just as with its liquidity bailout of Countrywide in August 2007, there was no quid pro quo. The Fed does not regulate investment banks, insurance companies, private equity firms, hedge funds, or thrifts. If it is going to hand out our money, it should ask for concessions designed to make the U.S. financial system safer—to do otherwise ratchets up moral hazard.
Yet, just as with the August 2007 liquidity bailout of Countrywide, the Fed extracted no concessions when it aided JPMorgan’s purchase of Bear Stearns and when it handed out massive liquidity to highly leveraged investment banks in the first quarter of 2008. It opened the national purse and let investment banks reach in.
In early April 2008, Fed Chairman Ben Bernanke testified before the U.S. Senate’s Committee on Banking in a speech devoid of inflationary language. His reason for the Federal Reserve’s agreement (in consultation with the Treasury Department) to provide funding to Bear Stearns through JPMorgan Chase was “to prevent a disorderly failure of Bear Stearns and the unpredictable but likely severe consequences for market functioning and the broader economy.”7
What happened to the $30 billion in Bear Stearns’ mortgage-backed products that the Federal Reserve bought through JPMorgan? From March to June 2008, it lost more than more than $1.1 billion in value; it has already eaten through JPMorgan’s $1 billion “cushion” and is now eating into taxpayer dollars. It is a sticky bomb, as dangerous as the makeshift explosives stuck
to tanks during World War II. In June 2008, the Fed admitted that it priced the assets as if we were in an “orderly market.”8 But we are not in an orderly market, so the price should be lower, meaning we do not know how much taxpayer money is at risk. Who is helping the Fed price these securities since it cannot price the sticky bomb itself ? Blackrock. Blackrock lost money when it invested in the Peloton fund that bought overrated and overpriced mortgage backed securities. They should know all about getting taken for a ride. Jamie Dimon claimed he by no means saddled the Fed with Bear Stearns’s riskiest assets. Given the performance of the assets the Fed took on board, JPMorgan’s shareholders may not feel reassured by Jamie’s testimony before the Senate Banking Committee.
Bernanke seems to think the Bear Stearns bailout did not create a moral hazard problem, because shareholders lost money. Bear Stearns’ share price bubble burst, but the Federal Reserve Bank inflated moral hazard. Shareholders in leveraged companies should expect to take risk. Bernanke bailed out Bear Stearns’ creditors. Investment bankers—not shareholders—are the key architects of the mortgage meltdown. Many investment bankers lost money on their own stock holdings, but others sold and diversified their holdings. Some earned high salaries and a significant portion of their bonuses in cash.
If the Fed feels investment bankers have learned anything from the Bear Stearns debacle, it might consider Jim Rogers’s point of view. “You don’t see any 29-year-old cotton farmers driving around in Maseratis,” he observed,“but you see a lot of 29-year-olds on Wall Street driving around in Masseratis.This is not the way the world is supposed to work.”9 Warren Buffett put it another way: “Wall Street is going to go where the money is and not worry about consequences.You’ve got a lot of leeway in running a bank to not tell the truth for quite a while.”10
Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street Page 23