I added up the probabilities. I picked one and Warren takes one of the other two and wins fourteen times. Then he says, “You want to do it again—for lunch?” So this time, I pick the die that Warren won with. Now he wins sixteen times. So I go back to the H-P. He’s sitting there with a shit-eating grin on his face.
For each die, one of the other two would always beat it. If you picked the right die and rolled enough times, you simply couldn’t lose. That was insurance: if you figured out the odds of a hurricane, or a three-car fatal, and priced your policies accordingly, you were playing with loaded dice.
Buffett had always been more involved in insurance than in his other entities, and had always known that—unlike, say, candy—insurance had the potential to grow off the charts. But in no other business had growth been accompanied by so many setbacks. In the 1970s, Berkshire had been burned by auto insurance fraud in Florida and disastrous levels of workers’ compensation claims in California. Its subsidiaries in Texas, Minnesota, and Iowa had been shut down altogether. And the growing tendency of juries to ladle out big awards had resulted in discomforting shocks. When Buffett met with his managers at National Indemnity, he would make a simple plea: “Tell me the bad news.”2 But despite their best efforts, his underwriters were repeatedly overly optimistic in estimating losses.3
In 1982—in effect, acknowledging his failure to manage the business—Buffett had asked Michael Goldberg, a thirty-six-year-old former McKinsey & Co. consultant who had been at Berkshire a couple of years, to run the insurance group. Goldberg was the exception to Buffett’s far-flung managers; he worked in the adjacent office in Kiewit Plaza. If anyone was suited for this impersonal terrain, it was Goldberg. As Goldberg said, Buffett was looking for “people with no ego.” Goldberg fit the bill.
A thin, intense New Yorker, Goldberg was physically evocative of Woody Allen. A colleague said it wouldn’t have surprised him if Goldberg’s IQ was 180. But, as a graduate of the elite Bronx High School of Science, he was used to being around smarter people still. From Buffett’s angle, his virtue was that he was even more allergic to risk than Buffett. A worrywart who lived for his work, Goldberg drove a dilapidated Oldsmobile that was so banged up that a subordinate once tore his coat on the chrome.4 At the time, Goldberg’s bonus was $2 million. He and his wife, who were childless, lived in a modest duplex not far from Buffett’s home. However, he and Buffett rarely socialized.
Their relationship was strictly insurance. Buffett liked to kick around mathematical puzzles with Goldberg (always in Goldberg’s office, so that Buffett was free to leave when he wanted). And Goldberg occasionally took policies to Buffett to get his okay. But Buffett made it clear that he didn’t want to spend a lot of time answering questions.5 What he did do was provide Goldberg’s group with a strong sense of direction.
Berkshire’s favored (but not exclusive) niche was “reinsurance.” This in effect is a wholesale business. Instead of selling thousands of small policies to homeowners or drivers, the reinsurer sells a few very big policies to other insurance companies, thus assuming a portion of the risks that its customers have underwritten. It is typically a “long-tail” business, meaning that claims are slow to develop. Thus, a reinsurer can reinvest the “float” from premium payments over long periods, only at the end of which will its profit (or loss) be known. It is hardly surprising that many reinsurers err toward optimism. Buffett put it rather wittily:
Initially, the morning mail brings lots of cash and few claims. This state of affairs can produce a blissful, almost euphoric, feeling akin to that experienced by an innocent upon receipt of his first credit card.6
The perennial problem is competition. As Buffett noted, all it took to increase the “supply” of insurance (unlike that of physical commodities) was the willingness of a provider to sign its name.7 Therefore, when prices were high, new entrants rushed in. This led to frequent, cyclical bouts of price-cutting. The first half of the eighties was one such period, with woefully inadequate prices. Buffett’s response to the slump, though, was unlike anyone else’s.
As Buffett liked to relate the business to poker, it is illustrative to consider his response to an actual wagering proposition. Every other year, he got together with Tom Murphy, Charlie Munger, and some other pals for a golf and bridge weekend in Pebble Beach, California. The men did a lot of betting, and at one session, in the early eighties, Jack Byrne, the GEICO chairman, proposed a novel side bet. For a “premium” of $11, Byrne would agree to pay $10,000 to anyone who hit a hole-in-one over the weekend. Everyone reached for the cash—everyone, that is, except for Buffett, who coolly calculated that, given the odds, $11 was too high a premium. His pals could not believe that he—by then, almost a billionaire—would be so tight and began to razz him for it. Buffett, grinning, noted that he measured an $11 wager exactly as he would $11 million. He kept his wallet zipped.8
Now, cut to insurance. While other companies cut prices to hang on to market share, Buffett recognized this as betting against the odds. So he and Goldberg refused to play. From 1980 to 1984, they allowed their business to shrink from $185 million in premiums to $134 million. If the business was unprofitable, Buffett didn’t want the business. Someday—he wrote this in 1982—losses would force providers to pull back, and prices would rise. In the meantime, he would wait.
It is natural to wonder why every insurer didn’t adopt such an approach. Their shareholders, and their managements, had been schooled on the principle of “steady” growth. To turn down business would violate the culture. At Berkshire, insurance operatives responded to a very different imperative. (In insurance, Berkshire did have a “culture.”) Constantine Iordanou, a division president in New York, said that when he wrote a policy, he was quite conscious that he was playing, as he put it, “with Warren’s checkbook.” This tended to inhibit Iordanou from betting against the odds.
In 1985, the insurance market did turn. The industry suffered severe losses and insolvencies, and many companies cut back the coverage they offered. The ability to provide insurance, in Buffett’s phrase, is “an attitudinal concept, not a physical fact.”9 By 1985, both the “attitude” of insurers and their capital reserves were depressed, and prices soared.
Buffett now reaped a double payoff for his prior conservatism. Big commercial customers realized that a promise from a potentially insolvent provider is no promise at all. There was a flight to quality, and Berkshire, which had six times as much as capital as the average carrier, had the soundest balance sheet of any insurer in the country.10 Thus, just as prices became attractive, Berkshire was very much in demand.
In mid-1985, Buffett took out a nervy advertisement inviting big commercial customers (who were hard pressed to find coverage) to submit policies for any type of risk with premiums of $1 million or more. There was a twist: respondents had to name their price. If Buffett (or Goldberg) deemed a proposal to be unreasonable, he would throw it out with the understanding that he would not grant a second chance. This poker ploy generated more than $100 million in premiums.
The strong-get-stronger scenario was even more pronounced in reinsurance. With their losses mounting, conventional insurers were scrambling for protective cover. But reinsurers, too, had been burned by losses. Few were able to answer the call, and fewer still were willing. Having lost money when prices were low, they were fearful of writing coverage at any price. Buffett likened them to Mark Twain’s cat: “Having once sat on a hot stove, it never did so again—but it never again sat on a cold stove, either.”11
Berkshire was now in a position to write very big policies, thanks to its capital and to Buffett’s “attitude.” He was perfectly willing to risk losing large amounts of money, even as much as $10 million on a single event such as a fire or earthquake, as long as the odds—the prices-were favorable. In the 1985 letter, one can hear him gloating: “Now the tables are turned: we have the underwriting capability whereas others do not.”12 In 1986, Berkshire’s premiums soared to $1 billion, seven times the level
of two years earlier.13 This translated to $800 million of “float” (dollars available for reinvestment), and to more than $1 billion the following year.
By 1987, Berkshire was stuffed with cash. However, it was far from clear what Buffett would do with it. He would “rather buy a good stock than a good jet,”14 he quipped, but he could not find one that was cheap enough. The bull market was in its heyday. In the spring, when Berkshire staged its annual meeting, the Dow was at an eye-opening 2,258 (and Berkshire at $3,450 a share). Buffett had quietly sold every stock in the portfolio save for the “permanent” three: Cap Cities, GEICO, and Washington Post. But he was stumped for a place to reinvest.
Buffett mistrusted forecasts—as he reminded shareholders, Ben Graham had been bearish when the Dow was at 400. But Buffett could not suppress his pessimism; in response to a question, he said he would not be surprised if the market—then at a precarious twenty times earnings—fell 50 percent. Share prices had lately been rising at a far, far faster clip than the 12 to 13 percent equity “coupon” that companies were actually earning. To Buffett, this suggested “a danger zone.”
A shareholder with a long memory asked if the climate resembled that of 1969, when Buffett had folded Buffett Partnership. At that time, Buffett recalled, “Opportunities were not available. I shoved the bottle away and returned the capital to my partners.”15 But now he could not cork the bottle; Berkshire’s operating subsidiaries—insurance, Mrs. B, et al.—continued to feed him cash. Buffett needed a place to put it.
Throughout the spring and summer, the stock market rally continued. In July, the Dow hit 2,500; in August: 2,700. There were snickers from the bulls; those, such as Buffett, who were on the sidelines were missing the rally of the century. Shares of Berkshire touched a new high—$4,270 a share. It hardly mattered. As in 1969, Buffett was shoveling money into municipal bonds.16 He had no decent alternative. Then he got a call from John Gutfreund, the chief of Salomon Brothers.
Since the bailout of GEICO a decade earlier, Gutfreund and Buffett had been in increasing touch.17 Lonely at the top, Gutfreund often called Buffett for advice. Buffett, in turn, admired Gutfreund as a cut above the average investment banker. Though known for his scalding sarcasm, Gutfreund was conservative in his approach to business. He had refused to let Salomon underwrite junk bonds and had generally avoided hostile raids, despite the lucrative fees associated with each. Instead, the firm had concentrated on trading. To Charlie Munger, Gutfreund evoked all that was noble in Salomon’s tribal culture, particularly its willingness to lay its capital on the line. He had a grandeur that the newer breed of executive lacked.
During the summer, Buffett had mentioned that he might be interested in buying stock if Salomon’s shares got cheaper.18 Though the stock had dropped by a third, it wasn’t at Buffett’s level yet. But the business was having trouble.
And Salomon’s biggest shareholder, Minerals and Resources Corp., or Minorco, was making restive noises. Minorco, controlled by South Africa’s Harry Oppenheimer, had retained Felix Rohatyn, the investment banker, who had let it be known that Minorco was anxious to sell. Though Minorco was sitting on 14 percent of his company, Gutfreund had let the matter drift—a fatal habit. Then, in mid-September, he learned that Rohatyn had found a potential buyer. Gutfreund was stunned to learn the buyer’s identity: Ronald Perelman’s Revlon.
Gutfreund had recently given in to his bankers and agreed to let Salomon enter the takeover business. How little he had suspected that he could be a target was evident from his breezy performance, earlier that year, in a roundtable on takeovers with Boone Pickens, merger lawyer Joe Flom, Drexel CEO Fred Joseph, prosecutor Rudolph Giuliani, raider Sir James Goldsmith, and Buffett.19 The moderator, Lewis Kaden, had conjured up the image of “Harry,” a typical, old-fashioned CEO, dedicated to building long-term values, who is suddenly threatened by a raider.
GUTFREUND: Let’s not waste a lot of time on Harry.
MODERATOR: [adopting the role of Harry]: What do you mean? I invented this company in my backyard.
GUTFREUND: You did a wonderful job. You were great in your time. Sorry, that’s life. The board will throw him out.
MODERATOR: Is that fair, to throw him out?
GUTFREUND: Fairness has nothing to do with it. There is no way you can turn the clock back. Now whether management is improved and does its own job or whether it’s taken over by somebody else … Harry is gone.
Now, when Gutfreund looked in the mirror, “Harry” stared back.
Gutfreund agreed to meet Perelman, who assured him that his intentions were “friendly” and that he would want Gutfreund to stay. However, Perelman added that he would want two seats on the board and intimated that he might buy up to 25 percent of the stock. Gutfreund was cool.20
Gutfreund’s supporting cast at Salomon was quick to note that Perelman was being represented by Bruce Wasserstein and feared that if Perelman won control, “Bruce” would soon be in charge.21 Perelman scoffed at the idea that he would spend his own money to get Wasserstein a job. He maintained, in an interview, that his motive was misunderstood. However, he was vague about what his motive was, beyond a general appreciation for Salomon’s business. In any case, Gutfreund didn’t trust him, and neither did Salomon’s brass.22 “They viewed him as Attila the Hun,” Rohatyn noted. Perelman was then in the midst of a second, very unfriendly raid on Gillette, from which he had already extracted greenmail.23 Martin Leibowitz, Salomon’s house mathematician, said, “People couldn’t have worked for Perelman. It was not who we were.”
Alas, it was late in the day for such high-mindedness. Minorco would sell to the first bidder that offered it a premium. Salomon could not itself afford to buy the block, and Perelman was ready to pay $38 a share (the market price was in the low 30s), or roughly $700 million. This was early in the week of Monday, September 21. Rohatyn figured that Salomon had until the weekend to find another investor. Gutfreund called Omaha.
Buffett arranged to meet Gutfreund and Gerald Rosenfeld, Salomon’s chief financial officer, a night or two later in New York, at the office of lawyer Marty Lipton, Gutfreund’s adviser. Buffett loped in tout seul, with a newspaper under his arm, in a white-and-blue seersucker, the lining of which was torn. Seeing his slouched frame, Rosenfeld drew a breath: this was Salomon’s savior?24
Buffett and Gutfreund went off by themselves to feel each other out. After half an hour, Rosenfeld joined them, and Buffett began to ask him about Salomon’s prospects, including where he thought the stock would be in five years. While they both agreed that the mid-6os was a likely number, Buffett thought Salomon too dicey for him to buy the common stocks.25 However, he was willing to invest in a “convertible preferred,” as long as Berkshire could expect to make an after-tax annual profit of 15 percent. As they talked, it became clear that Buffett had the terms of such an issue in mind.
Convertibles are the half-breeds of Wall Street. They have attributes of a bond: a fixed coupon and security of principal. They also enable a holder to convert to common stock. They are aptly described as Treasury bills with a lottery ticket attached. The holder has a safe investment and a chance to make a killing—though not as big a profit as on ordinary common.
Buffett insisted that Berkshire get a 9 percent coupon and a pair of seats on Salomon’s board—one for him, one for Munger. Salomon’s senior managers had a heated discussion over the terms, which they thought far too sweet for Buffett. “The feeling was, it had a very small premium [the conversion price was $38] and a very high dividend. Warren had it both ways,” William Mcintosh, the head of Salomon’s Chicago office, recalled. As a bonus, Berkshire’s $63-million-a-year dividend (like all such payments received by corporations) would be mostly tax-exempt. On the other hand, Buffett’s capital would enable Salomon to buy out Minorco at a premium—and rid it of the threat from Perelman. In the minds of Salomon’s executives, the choice between Perelman and Buffett was no choice at all.26
On Saturday evening, Gutfreund met Perelman again, f
or a drink at the swank Hotel Plaza Athenée on the Upper East Side. This time Gutfreund declared, politely but bluntly, that Perelman would not be welcome as an investor.27 Two days later, the offended Perelman indicated that he would accept the same security as Buffett, and with less attractive terms—but threatened, if he was rejected, to buy a controlling stake on the open market.28 Once again, Gutfreund snubbed him.
Then Gutfreund told his directors that they could either approve the Buffett deal, which would make Berkshire Salomon’s biggest shareholder, or find a new CEO.29 Prophetically, Gutfreund argued that Buffett would be a help to him in running the company. One director, Maurice Greenberg, strenuously objected,30 but the board went along. The only rationale for this rather expensive deal was the uncertain premise that somehow, down the road, Salomon would be better off with Buffett in control than Perelman.
When the news broke, in late September, Wall Street was stunned. The Wall Street Journal commented: “All the players seemed to fit-except one.”31 Buffett was putting $700 million—his biggest bet ever—into a firm of traders. His respect for Gutfreund figured heavily. “Charlie and I like, admire and trust John,”32 Buffett noted soon after. Moreover, the form of the security seemed safe. Ace Greenberg, the streetwise CEO of Bear Stearns, thought Buffett had made “a great deal for the shareholders of Berkshire Hathaway.” If Gutfreund had given away the store, that was his problem.
Still, Buffett took some heat. Forbes’s Allan Sloan pointed out that Buffett’s financing had enabled Salomon to pay greenmail to Minorco.33 And Buffett’s fans felt let down that Buffett had joined forces with Wall Street. A year earlier, he had disdainfully written that if a graduating M.B.A. had asked him how to get rich in a hurry, he would have held his nose with one hand and pointed to Wall Street with the other.34 Now, even the stalwart Carol Loomis was moved to write in Fortune:
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