The Snowball

by Alice Schroeder

  The image of Wall Street seducing a Midwestern populist into bed was too good to leave alone. Asked by a reporter why he owned the largest single chunk of Salomon when Wall Street was such a sinkhole, Buffett did not hesitate. He had placed his faith in one man. John Gutfreund, he said, “is an outstanding, honorable man of integrity.”4

  Buffett always did fall in love with people, and observers said he was noticeably in love with Gutfreund—at first. Yet the man who once quit his job as a “prescriptionist” to escape the inherent conflict of interest with his customers couldn’t shield himself with John Gutfreund from the basic fact that he owned part of an investment bank, which was riddled with conflicts of interests with its customers. How had he gotten himself into the—at best awkward—position of sitting on the board of such a company?5 It was as if, during a dry spell, Buffett’s urge to make money had once again overwhelmed his high hopes, high aspirations, and high principles. And as had been true throughout his life, whenever his avarice got the upper hand, trouble followed.

  At the time that Buffett invested in Salomon, the market was near a breaking point. In his shareholder letter the previous March, he had said that money managers were so hyperkinetic they made “whirling dervishes appear sedated.” He didn’t have a partnership to dissolve, but over the next few months he started dumping stocks. He knew that as the market continued upward, part of what was driving it was a new invention, the “S&P 500 future.” Salomon, like all major banks, now traded derivative contracts that were a way of betting how high or low the index of S&P 500 stocks would be on a certain date.6 Derivative contracts work like this: In the Rockwood Chocolate deal, the value of the futures contract was “derived from” the price of cocoa beans on a certain date. If the beans turned out to be worth less than the price agreed to by the contract, the person who had bought the futures contract as insurance “won.” Her losses were covered. If the beans were worth more, the person who had sold the futures contract as insurance “won.” The contract entitled him to buy the beans below the then-current market price.

  Suppose that in the weight deal Buffett had made with Howie for the rent on his farm, he didn’t want to risk Howie’s actually losing weight, which would drop the rent. Since this was under Howie’s control, Warren might want to buy insurance from someone else. He could say to Susie, “Lookit, I’ll pay you a hundred bucks today. If Howie loses twenty pounds and keeps it off for the next six months, you’ll pay me the two thousand dollars of rent that I’ll lose. If he doesn’t keep it off for the whole six months, you don’t have to pay me the rent and you get to keep the hundred bucks.” The index that determined the gain or loss was “derived” from Howie’s weight, and whether or not Buffett would make such a deal was based on a handicap of the odds that Howie would be able to lose the weight and keep it off.

  Another example: Suppose that Warren made a deal with Astrid to give up eating potato chips for a year. If he ate a potato chip he had to pay her a thousand bucks. This would not be a derivative contract. Warren and Astrid were simply making a deal. Whether Warren ate a potato chip was not “derived from” anything. It was under his own control.

  However, if Astrid and Warren made that agreement and then Astrid paid Warren’s sister Bertie a hundred bucks as insurance, in exchange for a thousand dollars if Astrid lost the bet, the deal with Bertie would be a derivative contract. It would be “derived from” whether Warren ate the potato chips, which was not under either Bertie’s or Astrid’s control. Astrid stood to lose the hundred bucks to Bertie if Warren didn’t eat the chips, and Bertie would lose a thousand bucks if he did. “Derivatives,” therefore, are either a type of insurance (for Astrid) or an outright gamble (for Bertie).7

  Most people buying and selling derivative contracts do so based on an impersonal index, setting the contract without ever meeting their counterparty. The S&P “equity index futures” that money managers were buying as insurance in 1987 paid them back if the stock market fell below a certain level. People who assumed the market would keep going up were often “gambling” by “selling” the insurance. They wanted income from the premiums.

  Buffett had written to Congress citing the risk inherent in these deals and urging regulation of this market as long ago as 1982, but nothing changed.8 Since then, equity index futures had swarmed like gnats in July. If stocks started to fall, all the bills would be presented to the sellers of insurance at once. They would have to dump stocks to meet their claims. The buyers of the index futures, meanwhile, were often using them to insure “program trades” that would sell automatically as the market fell, triggering a cascade of sales.

  By the early fall the market got nervous, and began to stutter and stall. On Black Monday, October 19, 1987, stocks plunged a record-breaking 508 points as everybody tried to squeeze through the keyhole at once. The market came close to a trading halt, as it did in 1929, and suffered its largest one-day percentage drop in history.9

  The Buffett Group happened to be meeting on the third day of the avalanche, this time in Colonial Williamsburg. Kay Graham had been put in charge of the arrangements, and she used Williamsburg’s atmospheric celebration of America at its purest, most patriotic moment to elevate the meeting from its formerly “slapdash, amateur effort by whoever,” as Buffett put it, to a whole new standard. The group was chauffeured everywhere, and members who were used to bran flakes at breakfast woke to find “enough food for a thousand people,” as one member described it, with chicken, steak, ham, and chicken livers served alongside their eggs. Graham hired Carter’s Grove Plantation, a historic eighteenth-century mansion fronting the James River, for a formal dinner one night and rented out a theater to screen a movie produced by Rick Guerin, some of whose money had been funneled directly into Hollywood. As the events crescendoed, each more elaborate than the last, the group was awestruck by the contrast with prior years, as well as by the expense. “How wonderful of Kay to have us as her guests,” Chuck Rickershauser said, as everybody in earshot nodded. On the final evening, Graham hired costumed chamber musicians to play Haydn during a private dinner at the DeWitt Wallace museum.10

  The topic planned for discussion as stocks were peaking had been “Is the Group finished with the market?” Instead, with the market crashing around their ears, for three days Buffett, Tisch, Gottesman, Ruane, Munger, Weinberg, and the others glowed like fireflies as they flickered in and out of the room, checking stock prices and phoning their traders with controlled excitement. Unlike the many people devastated by losses, they were buying stocks.11

  When the avalanche survivors were dug out of the snow, however, Warren’s sister Doris—now living in Fredericksburg, Virginia, the town she had fallen in love with when the family followed Howard to Congress—turned out to be one of the many people who had been “selling” the insurance. She had sold what were called “naked puts,” a type of derivative peddled by a Falls Church, Virginia, broker. Naked puts were promises to cover somebody else’s losses if the market fell—“naked” because they were unclothed by collateral and thus unprotected against loss.12 The broker had emphasized that the naked puts would provide Doris with a steady stream of income, which she needed. It is hard to imagine that the broker gave her any kind of realistic description of the risk she was taking, especially using a scary term like “naked put.” Doris was unsophisticated about investing but highly intelligent, with a hard-nosed common sense. She had not talked to Warren about the investment, however. He was famous for recommending only extremely safe, low-return investments, like Treasury or municipal bonds, especially when counseling divorced women. These were investments that he would never make himself. Doris had trusted him enough to become one of his first partners; she trusted him implicitly when it came to investing for Berkshire. But that long-ago childhood episode when Cities Service Preferred went down after he bought it for himself and Doris might have loomed large in both their minds, had she asked him for advice. She didn’t ask.

  Now, acting on her own, Doris had incurr
ed losses so large that they wiped out her Berkshire stock and threatened her with bankruptcy. Compounding her desperation, she had recommended the broker to some of her friends and felt responsible for the money they had lost as well.

  Doris romanticized her brother, viewed him as a protective figure, and kept a little shrine to him, featuring miniature golf clubs, Pepsi bottles, and other symbolic accoutrements of his life. But when she had a problem, instead of going to Warren, she called Susie as a go-between, as everyone in the family did. By this time Doris had been married and divorced three times. She felt she had rushed into her first marriage out of insecurity; her second had failed in part because she had felt coerced into it and thus hadn’t fought hard enough to save it. Her third marriage, to a college professor in Denver, had been a terrible misjudgment. By now, Doris had experienced a great deal of mistreatment in her life, but rather than letting it cow her, she fought back. This time, however, she didn’t know what to do.

  “You don’t ever need to worry,” Susie had told her about her brother after her third divorce. “He’ll always take care of you.”

  After she confessed to Susie what she had done and asked for help, Warren called her early on a Saturday morning. He said that if he gave her the money to pay her creditors, it would only help the businesses to whom she owed money—the counterparties whom she had insured. His logic was that they were speculators; therefore he would not bail them out. As she realized that this meant he was not going to help her, she broke out in a cold sweat and her legs started shaking. She was sure this meant that her brother despised her. He felt, however, that his decision was simply rational.

  “I could have given a couple million dollars to her creditors if I’d wanted. But, you know, the hell with them. I mean, this broker woman who sold this stuff to Doris—she’d busted everybody in that particular branch.”

  Doris hoped that Susie would save her. Susie had so much money of her own, and Warren gave her so much money, most of which she gave away. However, just as Susie had not given money to Billy Rogers for a down payment on a house, she did nothing now to help Doris financially.

  The story hit the Washington Post that the sister of “a highly successful investor” had done something extremely dumb. Damaging Warren’s reputation was a serious transgression in the Buffett family, and Doris’s timing was terrible. The Buffetts were still trying to recover from Billy Rogers’s fatal overdose just seven months before, another event that had publicly bared the problems beneath the family’s wholesome surface. Warren may have known—on some level—that he was rationalizing. Certainly he feared Doris’s ire; when she felt threatened—like Kay Graham—Doris defended herself as if cornered. Warren, of all people, genuinely understood his sister—but he could not tolerate shrill behavior from anyone, not even her. So he retreated. He stopped calling, and nobody else in the family contacted Doris. She felt as though the family had cut her off. Frightened at being abandoned and deeply wounded, Doris browbeat her mother for money and loans to prevent her from losing her home.13 Ironically, the Federal Reserve had lowered interest rates, companies were buying their own stocks, and the market was recovering quickly from the debacle, leaving only victims like Doris behind in its wake. In a sort of panic, she married Al Bryant, the lawyer who was helping her with her legal difficulties.

  But behind the scenes, Warren was arranging to advance his sister $10,000 a month from the trust left by Howard’s will. “That was more money than I have ever spent in my whole life,” she says. The tension deescalated; they were able to speak. She was almost prostrate with gratitude—until she realized that this was her own money, which she was simply being paid early. At the time, her share of the trust, having grown from a little over 2,000 shares of Berkshire that were worth $30,000 in 1964, was valued at about $10 million. The trust was not structured to pay out until Leila died, when Doris and Bertie would receive the money in four installments. As a further olive branch, however, her brother set up the Sherwood Foundation, which paid out $500,000 a year in charitable gifts. Doris, Warren’s children, and Astrid could each allocate $100,000 to any causes they chose. The annual income produced was as if her brother had put around $7 million into a trust for the five of them. Doris’s share, therefore, was almost as much as if Warren had given her the money after all, but in a different form.

  Of course, it was not in a form she could use to pay her debts or save her house—Warren never gave money outright, only in an earmarked manner that he controlled. Still, as the storm subsided, Doris regained perspective. She was grateful that he had gotten over his embarrassment and had helped her, in his own way. She was acutely aware that without him she would have had nothing in the first place. As she scraped together the money to pay her debts, their relationship gradually returned to normal, and the shrine stayed in place on her wall.

  The other victim of the crash that Buffett had to deal with was Salomon. Only three months after Berkshire’s investment, he and Munger attended their first board meeting. The topic of the day was the slump in trading and merger business at Salomon and the $75 million that Black Monday had cost the firm.14 Salomon faced the cleanup from Black Monday weakened by the fact that, only days before the crash, Gutfreund, his moon-shaped face impassive, had head-chopped even highly valued longtime employees, laid off eight hundred people, and discontinued marginally profitable businesses such as commercial paper trading (a backwater of the bond business) so abruptly that the disruption hurt relationships with some important clients almost beyond repair.15 These and the losses from Black Monday were going to gouge a deep hole in the shareholders’ pockets that year. And with that, Salomon’s stock fell into the tank.

  The shareholders were suffering, yet the compensation committee—which Buffett had joined at the request of its chairman, Bob Zeller—began to discuss lowering the price at which the employees’ stock options could be exercised.

  These options were rights to buy stock at a specified price in the future. If Salomon had been See’s Candies, it would be as if Buffett paid the line workers partly in pieces of paper that gave them the right to buy candy at a set price. If the price of candy kept going up every year, those pieces of paper kept increasing in value as time went along.

  However, right now the candy factory was having a bad year. See’s was going to lose money and its employees would suffer a cut in wages. The compensation committee was talking about lowering the price the workers would have to pay for candy to make up the difference. Buffett argued against this. The candy factory belonged to the owners—the shareholders—not the employees.16 He wanted the employees’ share of candy trimmed by exactly the amount that earnings had declined.17 The other members of the committee, however, felt the workers had been promised candy worth a certain amount when Gutfreund announced their packages a couple of months before, and when the candy went on sale, they were obligated to make up the difference. Perhaps they were trying to forestall the traditional Wall Street bonus-day stampede that occurs whenever people are unhappy: Take the money and run.

  Buffett felt this was morally wrong. Since the shareholders weren’t getting their earnings, why should the employees get their candy? The others outvoted him two to one. He was outraged.18 But his role on the Salomon board was mostly titular. His advice was rarely sought and less often taken. Even though Salomon stock by then was starting to recover, the repricing of the stock options, he says, “almost immediately” made his investment in Salomon “way less attractive financially than it had been.

  “I could have fought harder and been more vocal. I might have felt better about myself if I did. But it wouldn’t have changed the course of history. Unless you sort of enjoy combat, it doesn’t make sense.” Buffett’s willingness to do combat—even in a roundabout way—had diminished markedly since the days of Sanborn Map, Dempster, and the Buffetting of Seabury Stanton.

  “I don’t enjoy battles. I won’t run from them if I need to do it, but I don’t enjoy them at all. When it came to the board, Cha
rlie and I didn’t even vote against it. We voted yes. We didn’t even abstain, because abstaining is the same thing as throwing down the gauntlet. And there were other things at Salomon. One thing after another would come up that I thought was nutty, but they didn’t want me to say anything. And then the question is, do you say anything? I don’t get in fights just to get in fights.”

  Buffett had been originally attracted to Gutfreund, the reserved, thoughtful man in love with his work, who arrived every day at seven a.m., lit up the first of his huge Temple Hall Jamaican cigars, and wandered among the shirtsleeved traders to tell them, “You’ve got to be ready to bite the ass off a bear every morning.”19 Indeed, it appeared to employees who made presentations in board meetings that Buffett was a “relatively passive” board member.20 He seemed to understand little of the details of how the business was run, and adjusting to a business that wasn’t literally made of bricks-and-mortar or run like an assembly line was not easy for him. 21 Since he had made the investment in Salomon purely because of Gutfreund and now didn’t like the way it was working out, he always had another choice, which was to sell his investment and resign from the board.22 Wall Street boiled with rumors that Buffett and Gutfreund had had a falling out; that Buffett was either going to sell or to fire Gutfreund and bring in someone else to run the firm.23 But it hadn’t come to that. Someone as prominent as Buffett selling and resigning from the board as a major investor would be a shocking gesture that would drive down Salomon’s stock price and cost his own shareholders, as well as make him look capricious or vindictive or unreliable. By now his reputation had become part of Berkshire’s value. Moreover, he hadn’t given up on Gutfreund. His whole reason for investing was Gutfreund, and when Buffett threw his arms around someone, it took an ax to split them apart. Thus, as the holidays approached, he and Gutfreund struggled uneasily to work out their differences.