As the financial crisis evolved, the lame-duck Bush administration and the new Obama administration followed a consistent course under Federal Reserve Chairman Benjamin Bernanke and Treasury Secretary Timothy Geithner, with the Fed injecting trillions of dollars into the U.S. banking system, trying to forestall deflation—chronic falling prices such as occurred in 1932. The still unfolding crisis revealed its complex brew of causes, including artificially low interest rates, foolish borrowing by businesses and individuals, foolish lending by banks and investors, overreliance by institutions on complex financial instruments, aggressive behavior by derivatives traders, conflicts of interest at the banks being paid as agents to package loans sold to them by originators and resell them to investors, a climate of deregulation, lax oversight and enforcement by regulators, abdication of responsibility by rating agencies, inadequate capitalization of bond insurers, investor indifference—in other words, effects of all the normal dysfunctions that precipitate a bubble.
Of the responsible parties, it was the banks and AIG that earned the public's greatest ire, while Buffett became the public's greatest symbol of financial responsibility.
Treasury yields soon reached zero, but the flood of money failed to open the channels of business lending; credit remained virtually nonexistent. Buffett, who was at the time acting as the economy's greatest cheerleader, lent at interest rates that in some instances bordered on usurious—$150 million of twelve percent notes in Sealed Air; $300 million of Harley-Davidson debt for a fifteen percent interest rate; $300 million of ten-percent contingent convertible senior notes from USG; $250 million of Tiffany bonds at ten percent; and a $2.7 billion, twelve-percent perpetual convertible stake in Swiss Re that would give Berkshire a thirty-percent ownership in the insurance giant.
This latter move baffled insurance industry insiders, including Swiss Re employees. Swiss Re was General Re's biggest competitor; observers concluded that, on any terms, the investment to prop up Swiss Re made no sense because of its negative long-term strategic consequences to Berkshire—unless Buffett ultimately meant to take over Swiss Re and merge it with General Re. In the past, however, Buffett had made opportunistic insurance investments that worked against Berkshire's long-term interests. Challenged on this, he would respond, "If we don't do it, somebody else will." Thus it was equally likely that there was no strategy whatsoever behind the deal besides extracting some fast cash from the pockets of the Swiss.
Throughout, Buffett became an even more frequent presence on CNBC and other networks. He filled the role of America's statesman and father figure during the financial crisis, but he had also fallen into the trap of competing for attention instead of trusting that his sterling record would bring it to him. "Dignity, Warren, dignity," counseled one of his friends—but Buffett had never wanted to be dignified; he had never minded looking silly if it would get people to pay attention to him. He was a performer and a showman, and now he feared the show might end. He would keep on giving as many performances as possible while there was time. And indeed, his profile grew and grew in proportion to how often he appeared on the magic medium of television.
All this was not only personally effective—Buffett was his own best publicist—but also understandable for someone his age, until his marathon performances on CNBC resulted in some serious gaffes: criticizing newly elected President Obama's performance, giving advice to the White House (the Shoe Button Complex, something that Buffett had heretofore spent a lifetime avoiding), and a claim that he, like everyone else, had thought housing prices could only go up—an absurdity that raised eyebrows.
When Berkshire finally reported its 2008 earnings, the consequences of some of Buffett's earlier decisions became even clearer. The insurance businesses had suffered large losses from that year's unusually active hurricane season. "Last year was a bad year for a float business," Munger would later say at the shareholder meeting, citing GEICO and the energy and utility businesses as bright spots. Although Buffett referred to Berkshire's "Gibraltar-like" balance sheet, the erosion in its financial strength was unmistakable. Because of Berkshire's heavy insurance exposure and its concentration in financial stocks such as American Express, Wells Fargo, and U.S. Bancorp, its book value was down by 9.6 percent—only the second decrease in its history (and the largest). Berkshire had recorded $14.6 billion of accounting losses on its derivative contracts. While many of these losses would probably be reversed in the long run, they had a significant impact on the balance sheet. Nearly all of the decline was due to bets on financial assets that were market-dependent.
Even so, the decrease in Berkshire's book value was insignificant compared to major banks and nonbank lenders, which were technically insolvent or close to it, and receiving hundreds of billions in government aid. Buffett had steered Berkshire to a stellar performance, by that measure. All the work of many years had culminated in this moment: Berkshire standing alone after other businesses crumbled around it.
You would not know this by reading some of the commentary on Buffett. One of his challenges at this late stage of his long career was that he tended to be measured by some observers and journalists against a standard of perfection, as if he had to be infallible to be any good at all. Bloggers and financial writers went wild writing about Buffett's derivatives exposure. Buffett went on the counterattack. That year's shareholder letter contained a lengthy explanation of his reasoning for selling the equity-index puts. Yet by some calculations, under various scenarios Berkshire could indeed lose billions at the expiration dates of these contracts, which were not as well priced as Buffett had apparently thought when he entered into them. Ultimately, the concentration of financial assets and their effect on Berkshire's value was significant enough that first Fitch Ratings, then Moody's, downgraded the credit ratings of Berkshire and its subsidiaries (such as National Indemnity and MidAmerican) by one notch, from AAA or the equivalent.
The top rating had given Berkshire a lower cost of funding and significant advantages in its insurance business, which made it attractive to sellers of businesses. Buffett had displayed quiet satisfaction when Berkshire's two largest insurance competitors lost their triple-A ratings, and had at times said privately that the one thing he would never do was jeopardize Berkshire's triple-A, which he considered one of its most precious assets. In his shareholder letters, he liked to comment that Berkshire was one of only "seven," or whatever the dwindling number was, of the remaining triple-A companies. He considered it unlikely that this rating, once lost, would be reinstated.
Now Berkshire had suffered that blow, which it probably could have avoided by raising (expensive) equity capital, something Buffett chose not to do. At the 2009 shareholder meeting, he downplayed the consequences. He said the derivatives did not impinge on capital and that a triple-A rating only conveyed "bragging rights." "We're still a triple-A in my mind," he said. It was actually possible that Berkshire—in its uniqueness—could get the rating reinstated, but if so, it would be expensive even if Berkshire did not have to raise capital: It would have to reduce its exposures to insurance and equity market risk as a percentage of book value. Buffett probably would choose not to pay that price because its benefit was limited; no other financial institution remained with a triple-A rating.
Thus, the real meaning of the downgrade, in a larger context, was that the crisis had unveiled the true risk inherent in the global financial system—and the rating agencies had responded by increasing the capital threshold for a triple-A rating to a level that meant even the soundest institution found it financially unattractive to qualify.
Buffett also revealed at the 2009 shareholder meeting that to reduce Berkshire's derivative risk, he had renegotiated two of the equity-index put contracts, shortening the terms by eight years in order to lower the price at which Berkshire would have to pay out losses. By then, the values of Wells Fargo, U.S. Bancorp, and American Express had begun to recover, but Wells and U.S. Bancorp had cut their dividends, which would also affect Berkshire's future earnings. Buffett predicted that Wells Fargo would not have to issue stock, a prediction that was almost immediately contradicted when Wells Fargo did just that. He scored better a few weeks later when Berkshire's SEC filings revealed that he had been buying American Express while the stock was on its back.
Thus, during the financial crisis, Buffett made a series of characteristic brilliant moves interspersed with some surprising errors. Above all, he stood pat on existing investments while adding cleverly structured new deals, deals that for the most part were not available to ordinary investors. These opportunities came to Berkshire because of its ready cash and underlying financial strength, and because of Buffett's willingness to rent his well-earned reputation and provide quick, trustworthy handshake dealmaking.
The actions he had taken with deals struck in 2008 and 2009, in accordance with his saying "Cash combined with courage in a crisis is priceless," would enrich Berkshire shareholders for many years to come. At the same time, the crisis—which admittedly had so many episodes of heart-stopping disintegration into near economic collapse that in some ways it eclipsed the events leading to the Great Depression—left Berkshire a weaker company financially. It undercut Buffett's reputation as a nearly infallible manager, and cost the company its top financial rating.
The 2009 shareholder meeting would prove to be both a celebration of Berkshire's success and a chance for Buffett to defend himself. He had changed the meeting format so that half the questions would concern Berkshire and would be submitted through a panel of journalists: Carol Loomis, Becky Quick of CNBC, and Andrew Ross Sorkin of the New York Times. A torrent of five thousand questions poured in, many of them tough-minded queries from people who wanted answers but who had not, in the past, been willing to wait hours for a position at the microphone while others asked Buffett about his personal relationship with Jesus Christ and what books he and Munger had read lately.
The new format and the unsteady economy attracted what was said to be a record thirty-five thousand people in attendance despite Berkshire's stock price, which hovered at $90,000 per share. Buffett, who never said anything spontaneous, always seemed to have an answer prepared for every question that could be anticipated. The main difference in 2009 was that shareholders were asking truly challenging questions, rather than flattering him with their gratitude for being able to stand in his presence and receive his wisdom. At his most impressive he rattled off statistics and explained economics with a clarity that people were not hearing from anyone else. But his answers on other questions were more awkward. Buffett liked to deal with confrontation indirectly. Put on the spot, he behaved as he did in private, avoiding direct answers to some questions and meting out unpleasant information through hints and sometimes by omission.
Challenged on his decision not to sell financial stocks in the spring of 2008, he said he only sold when a company's competitive advantage disappeared, he lost faith in management, or he needed cash. He was cutting a fine distinction in trying to separate his criteria for selling stocks when companies' circumstances were changing materially all the time, versus selling whole businesses, which happened only when they became economically unviable or had persistent labor problems. With newspapers folding in cities all over the United States, he also went so far as to raise the possibility of eventually shuttering the Buffalo News, but said that as long as the News made a little money and had no labor problems, he and Munger would "keep it going."
Buffett was questioned sharply about why he did not sell Moody's when its business model was fundamentally compromised after the rating agencies were implicated in causing the financial crisis. He said he thought the odds were that Moody's was still a good business, and that he did not think conflict of interest—rating agencies are paid by the entities they rate—was "the major cause" of the problem. (Another conflict of interest, not mentioned, was Berkshire's twenty-percent ownership of Moody's when Moody's rated Berkshire.) Many in the audience had spent years listening to Charlie Munger's often repeated saying, "whose bread I eat, his song I sing," and understood that Buffett was rationalizing as he always did in pursuit of a profit or when he felt backed into a corner—or both.
When Buffett was asked how the four investment managers he had chosen as possible replacements performed during the 2008 market crash, and whether they were still on the list of candidates, he said they "didn't cover themselves with glory," then commented that neither did most investment managers during this period. Buffett did not respond to how these managers did relative to the market or to their relevant benchmarks. He left a vague impression that the list of candidates might change, over time.
What was certain, whichever candidates were chosen, was that the stock market would eventually recover. More important were Berkshire's businesses. Most were among the best in their respective industries. Buffett had built a conglomerate of stable businesses that were likely to be profitable for a long time. Still, the events of 2008 had certainly convinced many shareholders that Berkshire was not a company that could be run by a ham sandwich after Buffett was gone.
At the meeting they grilled Buffett about the question of succession with new intensity. The next CEO's challenges would be keeping Berkshire's managers happy, managing the company's franchise and risks, and investing the cash flow the businesses threw off. Buffett insisted that all the candidates were internal.
He said that running a major operating business was the best qualification for the CEO job. He next talked about what he actually did as CEO, which did not involve anything remotely resembling running an operating business (nor had Buffett ever run an operating business; nor could he have, had he been forced to do so). He stated that the operating managers had experience allocating capital—perhaps a necessary rationalization, although nobody truly allocated capital at Berkshire other than Buffett, particularly not in financial services, the heart of the company and the site of Berkshire's recent woes.
The answer revealed that Buffett was publicly introducing a rationale to pave the way for someone like David Sokol, the presumed front-runner who ran MidAmerican Energy. Buffett was also using a selection process that in some ways mirrored his two disastrous experiences at Coca-Cola, one that could someday put the board in an awkward spot.
To be sure, Buffett had already divided executive authority in a way that many outside candidates would not find comfortable—with his son Howie succeeding him as chairman, and Bill Gates taking on the role of de facto lead board member as representative of Berkshire's largest future shareholder, the Bill and Melinda Gates Foundation. This meant that, for better or worse, Berkshire probably would always be run in an unusual manner by unusual people.
The unusual company that Buffett—or Sokol, or possibly even a committee—would be running was stable and successful, and had, because of the financial crisis, gained relative advantage over its rivals in many of the businesses in which it operated, even though as of spring 2009 its results and financial condition also reflected the weakened economy.
As for the future, Buffett said retailing, especially of luxury products, might not recover for years. Companies like Borsheim's and NetJets were going to struggle. He said little more about NetJets; the sparsely populated aisles at Borsheim's on Sunday after the meeting spoke for themselves. On a brighter note, he said that new household formation was the key to recovery of housing related sales, with 1.3 million new households formed in the United States every year.
He spoke optimistically of the long-term future of the U.S. economy, which had survived two world wars, many panics and depressions, the resignation of a president in disgrace, and civil unrest. At various times, he had discussed what he expected to be inevitable inflation and the declining value of the dollar. Yet it was the "unleashed potential" of the human race that caused economies to grow over time, he said; in other words, productivity. The world's system to increase productivity works naturally and has been working for a long time. Munger waxed enthusiastic over Berkshire's investment in BYD, a Chinese maker of electric cars. We are about to harness the power of the sun, he said, and use more electric energy to preserve hydrocarbon energy for chemicals that are more important. The main technical problem of mankind is about to be fixed, he opined. Then he and Munger headed off to meet with the international shareholders, and Buffett and Astrid attended another round of parties on Saturday night.
Within days, Buffett would begin planning the 2010 meeting—when he would be almost eighty. He couldn't believe he would be eighty. Every year he attacked the meeting planning as though this year would be his ultimate statement—his greatest show on earth. In 2009, he had shown off an electric car. He would have to find some way to top that in 2010.
Meanwhile, to his slight chagrin, Borsheim's had missed out on one sale in 2009. (Every sale mattered to Buffett.) At 3:00 p.m. during the shareholder meeting, "Alex from Boston" asked Buffett what individuals could do to help the economy. Buffett said, first, to spend money, then repeated that new household formation would be helpful to the economy. With that, "Alex from Boston," who was Buffett's grandnephew Alex Buffett Rozek, asked his girlfriend Mimi Krueger to marry him. Mimi, stunned to be asked in front of thousands of people, said yes, and Alex gave her his grandmother Doris's sapphire-and-diamond ring, which Warren had given his sister for her seventy-fifth birthday.
Buffett the showman had always wanted to have a wedding at the Berkshire shareholder meeting, but had never quite managed to pull that off. He would settle for an engagement instead.
Tuesday, November 10, 2009
THE CRISIS: The decline of Berkshire Hathaway's stock from Triple-A status
From Alice Schroeder's new chapter: THE CRISIS: The decline of Berkshire Hathaway's stock from Triple-A status in the updated (and condensed) version of The Snowball.