In early 1996, Berkshire stock suddenly rocketed to $34,000 a share, valuing Berkshire as a company at $41 billion. An original partner who invested $1,000 in 1957 and left it untouched would now have $12 million stashed away—double the amount of just a couple of years before. Buffett himself was worth $16 billion. Susie now had $1.5 billion worth of Berkshire stock—which she had promised not to touch.7 Both she and Charlie Munger were now on the Forbes 400 list—as billionaires. Once invisible, Berkshire was noticed by people who had never heard of it before. That year, five thousand people from all fifty states came to the shareholder meeting–cum–discount mall.
Buffett took pride in having never “split” the stock and swore he never would. “My ego is wrapped up in Berkshire….” he said. “I can gear my whole life by the price of Berkshire.”8 But now it cost so much to buy a share of BRK that copycats set up investment trusts. Their idea was to mimic Berkshire Hathaway’s stock portfolio and let people buy in smaller units, as if it were a mutual fund. But Berkshire was not a mutual fund; it was a perpetual-motion vacuum cleaner that sucked up businesses and stocks and spit out cash to buy more businesses and stocks. That couldn’t be replicated by buying the stocks it owned. Among other things, you didn’t get Buffett.
Moreover, the copycat funds were buying the stocks that Berkshire owned at prices far higher than Berkshire had paid, and charging fat fees to do it. They were cheating investors. Now the cop in Buffett came out.
“I don’t want anybody buying Berkshire thinking that they can make a lot of money fast. They’re not going to do it, in the first place. And some of them will blame themselves, and some of them will blame me. They’ll all be disappointed. I don’t want disappointed people. The idea of giving people crazy expectations has terrified me from the moment I first started selling stocks.”
To foil the putative copycats, he decided to issue a new class of shares. Each B share—or “Baby B”—was equal to 3.33 percent, or 1/30, of a pricy A share.
He had great fun with the B shares, writing: “Neither Mr. Buffett nor Mr. Munger would currently buy Berkshire shares at that price, nor would they recommend that their families or friends do so.” He added that “current shareholders will not suffer any diminution in per-share intrinsic value, no matter how many Class B shares the Company decides it is necessary to sell.”9
By selling an unlimited amount of stock, they ensured that the price would not rise because of more demand than supply. “You don’t want people who think of it as something that can double, you know. And you can create your own market action for a while. I could have been a hero for a year as all the money poured into a fixed supply of stock. Instead, we said we would sell as much of this stuff as the world wants, and that way there is no way it can be a hot stock.”
At the same time, the inverted logic of selling stock that you wouldn’t buy yourself, and explicitly saying so, pleased Buffett enormously. Moreover, issuing the B shares fulfilled a duty to his shareholder “partners.” All that cash pouring in from the B shares would be a pretty good deal for them.
No CEO had ever done such a thing before. A small forest of trees was felled in media coverage of Buffett’s honesty. Yet investors gobbled up the B shares anyway. Buffett thought them foolish and said so privately and often. Yet there was no denying it was enormously flattering that they did, for they were clearly buying only because of him. He would have been secretly disappointed had the B share offering been a flop. The B shares were a Buffett no-risk deal: His shareholders won, and Buffett won, no matter how the offering turned out.
The Baby Bs forever changed the character of Buffett’s “club.” After May 1996, forty thousand new owners could call themselves shareholders. The next year he moved the meeting to the grimy old Ak-Sar-Ben Coliseum, and 7,500 people showed up. They spent $5 million at the Nebraska Furniture Mart. The meeting turned into Woodstock for Capitalists, or BRKfest. At the 1998 shareholder meeting, ten thousand people came. Yet as the money and the people and the fame came rolling in, an underlying shift took place in the world in which Buffett worked that would have profound effects on him and everybody else.
There really was no such thing as “Wall Street” anymore. Now financial markets were a string of blinking terminals connected by computers hooked up to the Internet that reached every corner of the world. A guy named Mike Bloomberg, whom Salomon had been dumb enough to fire back in the eighties, had created a special computer that captured every piece of financial information that anyone could possibly want. It made graphs, it made tables, it did calculations, it gave news, it gave quotes; it could do historic comparisons and set up competitions between companies and bonds and currencies and commodities and industries for whoever was lucky enough to have a Bloomberg terminal on his or her desk.
By the early 1990s, the Bloomberg terminal was becoming ubiquitous. The Bloomberg saleswoman had called Berkshire Hathaway for three years in a row. “Nope” was the answer every time. Buffett felt that following the market minute to minute and manipulating computers was not the way to invest. Finally it became obvious even to computer-averse Buffett that to trade bonds you had to have a Bloomberg terminal. But the Bloomberg sat some distance from Buffett’s office and he never looked at it; that was the job of Mark Millard, the bond trader.10
The advent of the Bloomberg terminal, symbol of the new computerized trading, mirrored the ongoing struggle over Salomon’s identity, which continued within the firm. Its laggard businesses had never gotten back on their feet. In 1994, Maughan had tried to realign pay at Salomon on the theory that employees should shoulder the same risk as shareholders. When times were good, they would get bonuses, but when times were bad, they would suffer as well. There were people inside the firm who agreed with him.11 But that was not the standard anywhere else on Wall Street, so thirty-five senior people walked out the door. Buffett was disgusted with the employees’ unwillingness to share the risk.
Deprived of Meriwether to bonus-pimp for them, the arbs fought for their share. Buffett was willing to pay them for results—the firm still made most of its money from arbitrage—but increasing competition made it harder for them to produce.
Arbitrageurs make a bet that a temporary gap of prices between similar or related assets will eventually tighten. For example, the bet may be whether two nearly identical bonds will trade at a closer price.12 With so much new competition, the easy trades had become scarcer. The arbs took larger positions with more risk. When they were losing, they doubled down and increased the size of their trades. In both cases, they did so because margins on trades were falling, and doing bigger trades, often using debt, helped offset that.
The rules of the racetrack said not to do so, because you don’t have to make it back the way you lost it. The reason is the math of losing money, which works like this: If someone has a dollar and she loses fifty cents, she has to double her money to make back what she’s lost. That’s difficult to do. It is tempting to borrow another fifty cents for the next bet. That way you only have to make fifty percent (plus the interest you owe on the loan) to get back whole—much easier to do. But borrowing the money doubles your risk. If you lose fifty percent again, you’re history. The loss has wiped out all your capital. Hence Buffett’s sayings: Rule number one, don’t lose money. Rule number two, don’t forget rule number one. Rule number three, don’t go into debt.
The arbs’ strategy, however, assumed that their estimate of value was right. Therefore, when the market moved against them, they only had to wait to make the money back. But “risk” defined this way—in terms of volatility—presumes the investor can be patient and wait. Of course, anyone who borrows to invest may not have that luxury of time. Moreover, to actually enlarge a losing trade required extra capital stashed somewhere that could be forked over on a moment’s notice if the need arose. And capital has an opportunity cost.
Larry Hilibrand lost $400 million—an enormous sum—arbitraging the difference in interest rates on mortgage-backed bonds. He was co
nvinced that he could make back the loss on the mortgage arbitrage if the firm would double his bet. Buffett agreed with Hilibrand in this instance and gave him the money for the trade—which in fact reversed to become profitable.
The arbs had an almost supernatural belief in their own abilities, and as their corner of the market became crowded, they wanted to expand into even more types of arbitrage that involved more variables and less certainty. They relied heavily on computer models driven by complex mathematics, but always said these were only guideposts. Buffett and Munger felt that using models to make investment decisions was like driving a car on cruise control. The driver might think he was fully alert and attentive, but would find out differently when the road turned winding, rain-slicked, and full of traffic.
What the arbs really wanted, however, even more than capital to invest, was J.M. During Salomon’s recovery, Meriwether waited on the sidelines at first while the arbs begged to bring him back. But while Deryck Maughan made polite noises, everybody knew he did not want Meriwether back. Nevertheless, Buffett and Munger had given a thumbs-up, with some conditions. Meriwether had to have supervision. He could return to his old position but would have to report to Maughan, with less freedom to run his operation. Unwilling to work under a shorter leash, Meriwether had broken off negotiations and in 1994 went off to found his own hedge fund, Long-Term Capital Management. It would operate the same way as the bond arbitrage unit at Salomon, except that Meriwether and his partners got to keep the profits.
One by one, Meriwether’s key lieutenants left Salomon to join him at the new harbor-front offices of Long-Term Capital Management in Greenwich, Connecticut. Deprived of his biggest moneymakers, Deryck Maughan saw the “for sale” sign heading for Buffett’s block of stock and began planning for the day when Buffett would wash his hands of Salomon.13
In his 1996 shareholder letter, Buffett said that “virtually all stocks” were overvalued. Whenever the market ran hot it was because Wall Street was in vogue. That year, Maughan thought it timely to pitch the restaurant in front of Salomon’s casino to Sandy Weill, CEO of Travelers Insurance, as the anchor tenant in a global financial shopping mall that could compete with Merrill Lynch. Weill supposedly still resented Buffett for the sweet deal Berkshire got after Weill’s squeeze-out in the Fireman’s Fund sale more than a decade earlier. He distrusted the arbitrage casino, but he saw an opportunity for the restaurant chain on a global scale. When he bought Salomon for Travelers, some observers felt that since Solly hadn’t done well under Buffett, Weill saw it as a chance to beat Buffett at his own game. Buffett hailed Weill for the decision as a genius at building shareholder value.14 And Travelers paid $9 billion for Salomon, bailing Buffett out of his problem-child investment.15
Meriwether, who knew that Buffett liked owning casinos, had gone to Omaha with one of his partners to try to raise money for Long-Term Capital for its February 1994 launch. They ate the now-obligatory dinner at Gorat’s, where J.M. pulled out a schedule over his steak to show Buffett different probabilities of results and how much money Long-Term could make or lose. The strategy involved earning tiny profits on many thousands of trades, leveraged by at least twenty-five times the firm’s capital. The highest loss that Long-Term contemplated was twenty percent of its assets, the odds of which it estimated at no more than one in a hundred.16 Nobody estimated the odds of losses bigger than that. (If they did, no one would invest; the numbers wouldn’t make sense. The projections in virtually all these types of models in every financial business always assumed the maximum “earthquake”-type loss could never happen—because the expected returns were never high enough to compensate investors for taking that risk.)
The name Long-Term came from the fact that investors were locked in. Meriwether knew that if he started losing money, he needed the investors to stay until the losses turned around. But so much leverage, combined with no way to cap the risk completely, made Buffett and Munger uncomfortable.
“We thought they were very smart people,” says Munger. “But we were a little leery of the complexity and leverage. We were very leery of being used as a sales lead. We knew others would follow if we got in.” Munger thought Long-Term wanted Berkshire as a “Judas goat.” “The Judas goat led the animals to slaughter in the stockyards,” he says, recalling Omaha. “The goat would live for fifteen years, and of course the animals that followed it would die every day as it betrayed them. Not that we didn’t admire the intellect of the people at Long-Term.”17
Long-Term charged its clients two cents off every dollar under management every year that they invested, plus a quarter of any profits it earned. Clients signed up for the prestige, but the “invest with a genius” approach put off other funds and firms on Wall Street. Nevertheless, it raised $1.25 billion, the largest hedge-fund start-up in history. The old arb team at Salomon now worked together in secrecy, with no outside interference and no more sharing of the profits with other parasitic Salomon departments. Indeed, the fund smoked in its first three years, quadrupling its investors’ money. By the end of 1997, Long-Term had amassed $7 billion of capital. Then competition from start-up hedge funds depressed returns. Meriwether sent $2.3 billion of money back to investors; the rest was all the market could digest. The hedge fund in Greenwich was now running more than $129 billion in assets—and a like amount of debt—on only $4.7 billion of capital. In a near-instant replication of Buffett’s steady accumulation of wealth, through the magic of fees earned on borrowed money, nearly half of the capital belonged to the partners themselves.18 Despite the fifty-year-old Meriwether’s difficulty making eye contact, he and his firm had a swagger to match their brilliant reputations, and the partners took full advantage of the fund’s position to dictate terms to its clients, to the fifty-something banks from which it borrowed, and to its brokers (in many cases these parties were one and the same).
Beating Buffett’s record was now the goal of most money managers in worldwide finance. Some thought Meriwether had at least an unconscious grudge against Buffett for failing to protect him at Salomon, then subsequently not hiring him back.19 Unbeknownst to anyone, Long-Term Capital was shorting Berkshire Hathaway, on the theory that BRK was overpriced relative to the value of the stocks that it owned.20 Not only that, Long-Term set up a Bermuda reinsurance company, Osprey Re, named after the copper osprey that sank its talons into helpless prey in the fountain outside Long-Term’s building. Osprey Re was going to insure earthquakes, hurricanes, and similar natural disasters—it was, in other words, entering Ajit Jain catastrophe reinsurance territory. The ditches on the roadside of the insurance highway were filled with wreckage. Buffett, the soul of prudence, had barely escaped himself once or twice in his younger days. Whenever a novice came along, better find the keys to the tow truck.
Gradually, as Long-Term’s coffers swelled and imitators followed for the next several years, through early summer of 1998, lenders collectively began to realize that, as periodically happens, they had gotten too euphoric about the prospects that all these people to whom they had lent money would pay them back. Long-Term’s competitors started dumping their dodgier positions as interest rates rose. That pushed down prices and set off a cycle of selling. But Long-Term had bet the opposite way, selling the safest assets and buying the riskiest, which were relatively cheaper. Its intricate models basically said that over time the financial markets were becoming more efficient, so the prices of risky assets would converge toward the prices of safer assets. Its biggest trades were a formulaic guess that the market would become less volatile, meaning that as the market bounced around, it would oscillate in smaller arcs. And historically that had been so. But as history had also shown, generally did not mean always. Long-Term knew that. It had made investors lock in their capital long enough to be safe—or so it thought.
On August 17, 1998, Russia suddenly defaulted on its ruble debt, meaning it would not pay its bills. When a major government stiffs its lenders, worldwide financial markets shudder. Investors began dumping everyth
ing in sight. A money manager had warned Long-Term, early on, that its strategy of eking out teensy profits on a zillion trades was like “picking up nickels in front of a bulldozer.”21 Now—surprise—the bulldozer turned out to have a Ferrari engine, and it was racing toward them at eighty miles an hour.
On Sunday, August 23, “I was playing bridge on the computer. I picked up the phone, and it was Eric Rosenfeld at Long-Term.” The boyish Rosenfeld, forty-five years old and one of Meriwether’s key lieutenants, was the person who had had the brain-numbing job of going through thousands of Mozer’s trades at Salomon and reconstructing what went wrong. Buffett liked Rosenfeld. Now he had been deputized by Meriwether to cut back the portfolio’s size by selling the firm’s merger arbitrage positions. “I hadn’t heard from him for years. With fear in his voice, Eric started to talk about me taking out their whole big stock arbitrage position, six billion dollars’ worth. They thought stock arbitrage was mathematical.”22 Responding reflexively, Warren Buffetted Rosenfeld. “I just said to Eric, I would take certain ones but not all of them.”
By a few days later, the market’s gyrations had cost Long-Term half its capital. The partners had spent a week talking to everybody in their well-connected database, trying to raise money before they had to report this dire news to their investors on August 31. No dice. Now they agreed that Larry Hilibrand—the superrationalist whose sobriquet on Wall Street was still “the $23 million man,” for the outsize bonus that had set Mozer off on his tear—would make a pilgrimage to Omaha and reveal what Long-Term owned.
The next day the Dow dropped four percent in what the Wall Street Journal referred to as a “global margin call,” with investors panicking and selling. Buffett picked up Hilibrand at the airport and drove him back to Kiewit Plaza. The modesty of Buffett’s smaller office, staffed by a handful of people and piled with Coca-Cola memorabilia, contrasted markedly with Long-Term’s enormous digs in Greenwich, which featured two pool tables and a three-thousand-square-foot gym staffed by a full-time trainer.
The Snowball Page 86