Prime brokers provide hedge funds with a variety of services:They provide financing for leverage; they set up custody accounts for their assets; they act as a settlement agent; and they prepare account statements for customers. Smaller hedge funds often rely on their prime brokers for risk management and trade ideas. These smaller hedge funds also tend to drastically underestimate the cost of doing business. Fortunately for hedge fund managers, the fees fund managers charge can add up faster than the miscellaneous charges on a phone bill. If the hedge fund documents allow loans to management, the lowest returning asset in the hedge fund portfolio may be an invisible low-cost loan to management.
The investment bank symbiosis did not stop with hedge funds. Investment banks also provided loans, assistance, and even management staff to structured investment vehicles (SIVs), and collateralized debt obligation (CDO) managers, some of which also manage hedge funds.
Undercapitalized managers are easily influenced by an investment bank that set them up in business and trades with them. If an investment bank has a large inventory of overrated and overpriced mortgage loan or leveraged loan-backed securities that it needs to get off of its books, it is very convenient to have symbiotic relationships with structured investment vehicles, collateralized debt obligation managers, and hedge funds. As investment banks needed to get bad loans off of their balance sheets, institutional investors became the prey of both hedge funds and investment banks.
As General George S. Patton observed: “A pint of sweat saves a gallon of blood.” Warren Buffett and Charlie Munger would not tolerate the kind of risk that would wipe out a lifetime of hard work, and look for a margin of safety when they make a purchase. Their decades-long track record beats all of the top hedge fund managers. Berkshire Hathaway does not promise to do well in both up and down markets. There are years when the value of the stock decreased or underperformed the S&P; but long-term value investors do not concern themselves with chasing a market return.Warren looks for value and for companies that he is happy to own even if the market closed for five years and he couldn’t trade any of the shares.
As a disciple of Benjamin Graham, Warren Buffett does not distinguish between value and growth companies, since the concepts are Siamese twins. Why would you buy a fair company at a good price instead of a good company at a fair price? If possible, try to buy a good company at a good (cheap) price, and a good company has good growth potential.
Berkshire Hathaway defines value companies as those selling at or below a fair price—book value combined with earnings—that have high earnings growth potential relative to alternatives. The price has to make sense and the fundamental economics have to be good. A company (or hedge fund) could produce steadily rising earnings by investing in T-bills, and passive compounding would cause capital earnings to steadily rise even if the company did nothing to generate additional shareholder value. Yet Warren would not consider this to be a value company.
Returns are not kept secret.They are available to the general public on Berkshire Hathaway’s Web site. From 1965 to 2007, the S&P 500 (including dividends) has had a compound annual gain of 10.3 percent and an overall gain of 6,840 percent. For the same period, Berkshire Hathaway has shown adorable alpha; it had a compounded annual gain of 21.1 percent and an overall gain of 400,863 percent.42
In June 2008, Warren Buffett issued a challenge to hedge funds. He has bet Protégé Partners LLC, a fund of hedge funds, that five hedge funds of its choosing will not produce averaged returns net of fees over the next 10 years above the S&P 500. Buffett and Protégé each staked $320,000 to purchase a $640,000 treasury zero that will be worth $1 million in 10 years when the results are in (around a 4.56 percent annualized return—perhaps a better performance return than the hedge funds), and the $1 million will go the winner’s charity. Warren chose Girls Inc. of Omaha, and I am sure they will be delighted when they receive the money.43
Chapter 5
MAD Mortgages—The “Great” Against the Powerless
The manufactured housing industry’s business model centered on the ability . . . to unload terrible loans on naïve lenders . . . The consequence has been huge numbers of repossessions and pitifully low recoverie[s].
—Warren Buffett,
Berkshire Hathaway 2003 Annual Report
Berkshire Hathaway’s 2003 annual report arrived in my mailbox in April 2004. Reading it, I learned that Berkshire Hathaway had acquired Clayton Homes, the largest U.S. manufacturer and marketer of manufactured homes. Unlike Oakwood Homes, a Berkshire Hathaway investment that lost money in 2002, Clayton Homes is well managed and practices sound lending through its Vanderbilt Mortgage and Finance Inc. affiliate. Clayton Homes is noted for the good character of its management in an industry rife with corrupt practices where buyers who could not afford homes were steered into fee-bloated loans created by lenders who should not have lent to them.Warren had learned about those practices the hard way after purchasing the distressed debt of Oakwood Homes, another manufactured housing company, which went bankrupt in 2002. Warren wrote: “Oakwood participated fully in the insanity.”1
Oakwood Homes (Oakwood) designed and manufactured modular homes and sold them either directly to home buyers or to independent retailers. Oakwood provided loans to buyers of its homes. On its own, Oakwood did not have money to lend. Oakwood got money through a line of credit from Credit Suisse First Boston (Credit Suisse). The credit line was similar to a credit card except that Oakwood had to put up the home loans as collateral. Credit Suisse earned fees for the loans and further fees when it packaged (securitized) Oakwood’s loans. Credit Suisse (the “old investor”) bought the securitized loans and then sold them to so-called sophisticated private and institutional investors (the “new” investors).
Many of Oakwood’s “home buyers” had not actually bought a home; they had assumed a mortgage loan they could not pay back. Sales declined. Loan delinquencies (late payments) and repossessions rose. Oakwood Homes had crushing debt and falling income for at least three years before it filed for bankruptcy in November 2002.
Oakwood and Credit Suisse sued each other.These nice kids found each other in a dangerous playground; and they courted each other for years, long after the affection had gone. The court issued an opinion in June 2008.The documents said Oakwood’s aggressive lending practices led to the high number of repossessions and a debt load that Oakwood could not support; Oakwood’s liquidator called the transactions it did with Credit Suisse “value destroying.”2 The court said that Oakwood’s own alleged wrongful conduct prevented it from recovering any money from Credit Suisse; there was equal fault. Basically, the court shrugged at the liquidator’s claim: lay down with dogs, wake up with fleas. An exception to this would have been if Credit Suisse were a corporate insider (say, if Credit Suisse had an officer on Oakwood’s board—which it did not), but Oakwood’s board and management made its own decisions.
Warren Buffett learned that the manufactured housing industry’s consumer financing practices were “atrocious,” and securitization made the situation much worse. Investors in the securitizations supplied money to investment banks who lent to manufacturers and retailers, who then lent money to home “buyers” in the form of mortgage loans or real estate investment contracts. Since the ultimate so-called sophisticated investors, the buyers of the securitized loans, were so far removed from the source of action, they often failed to thoroughly check on what they were buying. Warren learned about the Ponzi-like business models in mortgage lending and securitization market fairly early on. He wrote shareholders (in the annual letter) about his disastrous experience and what he learned from it; then he posted the information on the Berkshire Hathaway Web site for the world to see.The financial industry had not behaved well.The problem was fueled by “buyers who shouldn’t have bought, financed by lenders who shouldn’t have lent.”3 If Wall Street read Warren’s shareholder letter, it either missed his message or walked away with an idea of how to expand on a bad theme.
No mat
ter what hedge fund or investment bank one works for, no matter how lofty the title, no matter how successful the investor, they are all subject to My Theory of Everything in Finance:
The value of any financial transaction is based on the timing of cash flows, the frequency of the cash flows, the magnitude of cash flows, and the probability of receipt of those cash flows.
In finance, we make up a lot of fancy and difficult to pronounce names and create complicated models to erect a barrier to entry that keeps out lay people. High barriers tend to protect high pay. I’ve written books about some of the esoteric products: credit derivatives, CDOs, and more, but before I look at the latest hot label dreamt up, I look at the cash to find out what is really going on. I also ask a lot of questions.
Everything trades off the next most certain financial instrument, usually starting with U.S. treasuries as the risk-free benchmark.The price will fluctuate, going up as interest rates fall and going down as interest rates rise. U.S. Treasuries have the virtue of usually having a known coupon that will be paid on known dates and a known maturity date. If we all agree on how to discount those cash flows, the entire market will come up with the same price. With every other security, I will have an opinion about when and whether I will get my cash back. To form that opinion, I need to know if the company, consumer, hedge fund, investment bank, or other entity is good for the money.
Why would any diligent financial professional hand over money without asking tough questions of strangers in the marketplace? If a flaky brother-in-law who you wanted to help asked you for a large loan, you would probably grill him before you forked over thousands of dollars. There would be no point in letting him get in over his head since that wouldn’t be a loan, it would be something else: When will you pay me back? How much interest are you promising to pay? How often and when will those payments occur? Do you have any collateral? Do you have any other debts? What is the probability you will hang onto your job this time, so that you will have the money to pay me when it is due? You would probably come up with even more questions, and this is for someone you know. You know how to find him if he doesn’t pay, and you both have an interest in keeping the relationship going.
If it looks as if there will be a problem getting money back from a borrower, walk away. The most important part of My Theory of Everything in Finance is the Buffett Rule: Do not lend money to people who cannot pay you back.
During the South American debt crisis in the 1980s, U.S. banks warned it would be disastrous for South American governments if they did not pay back their debts. The banks got it partly right. If you are owed billions of dollars by a third world country, and it cannot pay you back, the third-world country is not in trouble, you are.
Investment bankers are astute worldly people, and they keep their fingers on the pulse of the global financial markets. However, they tend to run with the herd. After getting badly burned by making unsecured loans to those who couldn’t pay back the money, loans backed by assets were marketed as being a safe alternative. Loans backed by collateral such as homes and commercial property were viewed as particularly safe because one could seize the property and sell it if the borrower could not pay.
After the late 1980s thrift crisis, during which savings and loans that made mortgage loans throughout the United States went bankrupt, the government took a more aggressive role in the U.S. housing market. A network of Federal Home Loan Banks makes low-cost loans to banks and financial institutions so that they can lend money to mortgage borrowers. The Federal Housing Administration, FHA, part of the United States Department of Housing and Urban Development, or HUD, insures mortgage loans made by FHA approved lenders. These FHA loans are then sold to GNMA (or Ginnie Mae) a government agency that packages (securitizes) the loans for investors. Ginnie Mae “packages,” known as agency passthroughs (they pass through interest and principal payments to investors), are backed by the full faith and credit of the U.S. government, meaning U.S. taxpayers. Fannie Mae (FNMA) and Freddie Mac (FHLMC) were privately chartered United States mortgage giants regulated by HUD. While Fannie and Freddie were private and their securitizations were not guaranteed, the overall sense was that they were (1) too big to fail; and (2) had the implied moral obligation of the U.S. government (that would be you, the taxpayer). Freddie Mac and Fannie Mae are now so huge that many believed a default by either of them would cause a crisis of confidence and the global markets would collapse—they are too big to fail. Too big to fail means American taxpayers will pay for a bailout. It turns out this thinking was correct. In September 2008, both Fannie Mae and Freddie Mac were placed in conservatorship. A new regulator, the Federal Housing Finance Agency (FHFA) fired (and replaced) the CEOs, fired the former boards of directors, and took control in a form of nationalization. With so much at stake—meaning U.S. government funds obtained from taxpayer dollars—one would think that HUD, the FHA, Fannie Mae, Freddie Mac, and the 12 Federal Home Loan banks (plus the army of regulators that oversee them) would make sure that the lending is prudent, because if it is not, the U.S. government will have to pay. Sadly, that has not been the case, perhaps because the government feels it is dealing with other people’s money—the money of the U.S. taxpayer. Mortgage lending practices in the United States are tightening up, but there is still a long way to go to get back to prudent lending. As for the new regulator, it is headed by James B. Lockhart, who also oversaw the old regulator (the Office of Federal Housing Enterprise Oversight or OFHEO). It seems to me that the new sheriff looks a lot like the old sheriff.
Fannie Mae and Freddie Mac purchase mortgage loans from mortgage lenders and earn fees for guaranteeing payments on other mortgage loans.To prevent losses, Fannie Mae and Freddie Mac have requirements for the types of loans they will buy. But, they came under pressure to relax those standards, and their risk increased as a result. Fannie Mae and Freddie Mac package up these loans and create securitizations known as conventional passthroughs. Some mortgage lenders cannot keep going if Fannie Mae and Freddie Mac refuse to buy their mortgage loans. In this way, Fannie Mae and Freddie Mac are indirect mortgage lenders.
Fannie Mae and Freddie Mac are highly leveraged, and they were extremely vulnerable to failure. If you are highly leveraged, you must keep the quality of the mortgage loans very high, because a small decrease in value is amplified by leverage. But if you have it in the back of your mind that you can have a colossal screw-up and someone will bail you out, it almost guarantees you will make lousy financial decisions. It is a crazy way for any investor to think. It is the antithesis of Benjamin Graham’s philosophy. Warren told me that, as an investor, everyone makes mistakes, but you don’t have to do a lot right as long as you avoid big mistakes.
Fannie Mae and Freddie Mac appeared to be careful back in the day. Loans had to “conform” by meeting lending guidelines so the borrower had a good chance of paying off the loan: the borrower’s income had to be verified and documented; total housing cost including insurance and fees—no more than 28 percent of borrower’s gross income; total debt (including credit cards, auto loans, etc.) less than 36 percent of borrower’s gross income; the borrower’s payment history could not include too many late payments. The borrower’s money for the down payments and closing costs should come from his own savings, not from, say, a “gift” (which may in reality be a loan) from a relative. The borrower should have a steady job for at least two years, and enough extra cash to cover at least two months of all living expenses and other obligations.This is called prudent lending, and it protects both the lender and the borrower. Prudent lending practices protect the United States economy from mischief makers whose actions, intended or otherwise, could upset the entire U.S. housing market. But as prudence gave way to politics born out of greed, HUD stopped being part of the solution and became part of the problem.
For more than a decade, prudent lending seemed to assuage the fear of losses; but “creative” investment banking ruined even that supposedly safe scenario. If you set up a countrywide system wher
e you overstate the value of an illiquid asset and then lend to borrowers who will have a hard time paying you back, you create bad loans on a massive scale. Cheap money available for loans pushes the prices of homes well above the price of the underlying land and cost to build plus reasonable profit; the prices keep getting pushed upward based on imaginary value and paid for with loans for which few questions are asked. It is as if you created your own third-world country in a bubble.
In contrast, Warren Buffett’s Clayton Homes (through Vanderbilt Mortgage) maintains prudent lending standards—that require a certain down payment, proof of income and employment, a reasonable debt to income ratio—the kind of standards that keep people in their homes and paying their mortgage.
Suppose there is an unemployed man with no source of other income other than his representation that he is a successful Internet day trader. Up until now, he has not been very successful at anything. He has a poor credit history, and he wants to buy a home he could not previously afford. Fortunately, he says he has a flair for gambling—I mean—day trading, on the Internet. He does not wish to provide documents verifying his success, because the key to his successful formula is that is must remain confidential. Furthermore, he does not want to make a down payment on a home since his capital is tied up in his successful Internet day trading strategy, which he says is more profitable than the housing bubble—I mean housing investment. Why tie up money in a down payment when he can use that money to gamble—I mean—increase his fortune?
Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street Page 9
