Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street
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The Fed’s terms mirrored those that nervous investors refused when they stopped buying Countrywide’s debt.The Fed bailed Countrywide out of its liquidity problems by lending to the banks who lent to Countrywide using Countrywide’s collateral to back the loans. This massive liquidity bailout was the first Fed bailout related to the subprime mortgage lending crisis (as far as I know). The Federal Reserve Bank could have exercised its authority to demand Countrywide modify mortgage loans.The Fed was a pushover. Ben Bernanke had dangled raw meat in the face of hungry wolves. More bailouts were coming.
Investors felt pressure from all angles. Quant funds reported losses. I told CNBC’s Carl Quintanilla that quant funds put on Dead Man’s Curve trades, and “model masturbation makes quants go blind.”Warren Buffett and Charlie Munger warned this would happen. They talk about value and price; they don’t talk about betas, correlations, and volatilities. Steve Forbes of Forbes magazine opposed any bailouts. He noted the Fed had kept rates low, fueling the problem. He cautioned that we should “resist the temptation to bail these people out,” and specifically referred to the Fed’s bailout of Long-Term Capital.27
On August 17, 2007, CNBC aired a series of stories that Warren Buffett might be eyeing Countrywide, but they were all incorrect stories. 28 “It is better to be a bad manager of a good business,” Warren always says, “than a good manager of a bad business.”29 He seeks good managers of good businesses. I told the Journal Inquirer that the Fed should have asked Countrywide for a quid pro quo in exchange for the bailout: “Given Countrywide’s contribution to the problems in the mortgage loan market, and given company head Angelo Mozilo’s denial of that role, the Fed should have pressured Countrywide’s board to replace him.”30 Warren wrote me that he agreed with my comments.
Less than a year after the August 2007 bailout, Daniel Bailey Jr. got a surprise email reply after asking Countrywide to modify the terms of his adjustable rate mortgage. Bailey Jr. wrote he had not understood how the loan worked; he had been told he could refinance after a year; and now he cannot deal with the payments. Mozilo apparently hit “reply” rather than “forward” when emailing. Mozilo wrote it is unbelievable that most of the letters Countrywide receives seem like form letters. “Obviously they are being counseled by some other person or by the Internet. Disgusting.”31
I can understand the email SNAFU. One Saturday, I sent my nephew, Kenneth, a link to a cheesy but oddly entertaining David Hasselhoff video.Three hours later, Kenneth C. Griffin, CEO of Citadel Investment Group, replied, “Did you hit my address by accident?” I know Ken Griffin is a gentleman. He promised not to embarrass me by revealing my mistake. I now also know we are both fans of KITT (Knight Industries Two Thousand), the talking car in Knight Rider. KITT protected Michael Knight, Hasselhoff ’s character, but no one seems to protect borrowers from predatory lenders. I understand how easy it is to miss-send an email. But I cannot understand why Mozilo was still CEO of Countrywide and in a position to send it. Mozilo stayed on as Countrywide’s CEO until the week after its acquisition by Bank of America was approved by Countrywide’s shareholders on June 25, 2008.32 Warren is a fan of buying large positions in good stocks, and he is also a fan of Mae West, who once said: “Too much of a good thing can be wonderful.” I am pretty sure Mozilo’s delayed retirement is not what either of them had in mind.
By the spring of 2008, it was painfully clear that mortgage loan losses would be much higher than the Fed’s earlier highest projections, and my numbers were closer to reality. The overall size of the U.S. residential mortgage loan market is around $11.5 trillion, of which a little more than 11 percent is subprime and more than 10.4 percent is Alt-A (with credit scores in between subprime and the higher prime borrowers). John Paulson of Paulson & Co. compiled data from LoanPerformance and the Mortgage Bankers Association in a public presentation showing that between March 2007 and March 2008, subprime delinquencies had soared to 27.2 percent in the $1.3 trillion subprime market, an increase of around 163 percent, and in the $1.2 trillion Alt-A market, delinquencies soared to 9.1 percent, a year over year change of around 380 percent. Prime mortgage delinquencies were up to 3.2 percent, a 2.1 percent increase from fourth quarter of 2006 to 2007.
Given the gravity of the loan problems, investment banks should have been reporting large losses much earlier. For example, on October 8, 2007, I told clients that Merrill’s mal de MER was just beginning. At the time a friend asked me where Merrill stock would be in six months. I responded: “In someone else’s portfolio.” Not mine and not Warren Buffett’s. Jeff Edwards, Merrill’s CFO had made rosy statements in July 2007. Astute shareholders, not to mention the SEC and Merrill’s board, might have wondered why the massive losses reported in third quarter had not shown up much earlier. Stan O’Neal, the CEO, appeared to have a big problem.
On October 10, 2007, I reminded David Wighton of the Financial Times that Merrill was one of the lenders to the mortgage-backed securities hedge funds managed by Bear Stearns Asset Management that collapsed in August 2007. Creditors had challenged BSAM’s mark-to-market valuations in April, and that is what got the ball rolling for the downfall of the funds: “Merrill was not so finicky when it came to marking its own books.”33
Merrill began reporting massive losses, but in my view, they were quarters late. I was amazed O’Neal was still in his CEO chair. On October 24, CNBC’s Joe Kernen, with GE’s former CEO, Jack Welch, covered Merrill’s earnings report. I appeared on a segment with Charlie Gasparino, CNBC’s online editor.
I led off: “Way back in first quarter” I had called this and said Merrill’s risk managers should “get out and short. Short Merrill’s positions.”34
Gasparino asserted: “When we were reporting this about three weeks ago, ahead of everybody . . . we reported there was going to be a larger third quarter loss.”
I countered that O’Neal has a big problem: “They were not hedging properly in first quarter.” I added: “I laughed in disbelief” when I saw second quarter earnings. “It is an Enronesque kind of problem, it is a business management problem, not a risk management problem.”
Gasparino said he wouldn’t go that far and focused on the CFO (Jeff Edwards) and the potential ouster of a risk manager instead of picking up on my assertion about O’Neal. He said the problem with getting rid of Ahmass Fakahany: “Fakahany (the risk manager) and Stan O’Neal are very close.”
“I don’t think O’Neal survives this,” I responded.There is no problem getting rid of O’Neal’s friends if he is gone, and O’Neal will have to answer to shareholders and the board about failure to report losses in second quarter. Within a few days, O’Nal resigned. I added that the rest of Wall Street had underestimated how horrific the losses due to low recovery rates would be in subprime.35
After the collapse of the stock market technology bubble and the outing of Enron’s and Worldcom’s problems, Stan O’Neal wrote an opinion piece for the Wall Street Journal saying,“In any system predicated on risk-taking, there are failures, sometimes spectacular failures. But for every failure to be viewed as fraudulent or even criminal bodes ill for our economic system.”36
I agree with O’Neal’s words on the face of it. It’s great to have an open mind, but don’t leave it so open that your brains fall out. O’Neal might have added that taking foolish risks and then failing to examine risk in one’s own portfolio makes for poor financial management. CEOs can read the newspapers just like anyone else, and the implosion of mortgage lender after mortgage lender was well publicized.Warren Buffett is a voracious analytical reader, and he told me that he considers risk management one of his key responsibilities as CEO of Berkshire Hathaway.
If O’Neal did not have time to read the papers, he might have asked a few more questions of his managers about Merrill’s involvement with failed mortgage lenders like Ownit. How could Merrill resell or securitize those loans and earn the same profits healthy loans produce?
The Department of Justice and the Federal Bureau of Investigatio
n (FBI) issued a press release on June 19, 2008: “From March 1 to June 18, 2008, Operation Malicious Mortgage resulted in 144 mortgage fraud cases in which 406 defendants were charged.” Cases have been brought across the United States with losses of approximately $1 billion induced by alleged fraud.37
When Bank of America Corp agreed to buy Countrywide in January 2008, the all-stock transaction was valued at $4 billion. By the time Countrywide’s shareholders approved the sale on June 25, 2008, the shares of Bank of America had slumped and the value was around $2.8 billion. But Bank of America may not have gotten a bargain. Also on that day, Illinois, California, and Washington State Department of Financial Institutions filed lawsuits against Countrywide, and other states soon followed.3839 Illinois Attorney General Lisa Madigan was the first to file, and the Illinois suit named Angelo Mozilo in addition to Countrywide. She noted that Mozilo has assets. She alleged there was a “pattern of deception.” Countywide had the “worst practices” and the “highest volume” of troubled mortgage loans in Illinois, and the “most toxic product (option ARMS), which she said makes up one-third of Countrywide’s portfolio. “Countrywide broke the law. Homeowners did not.”40
Eric Mozilo, the CEO’s son, blamed the media, protesting, “All we try to do is put people in homes.”41 He may be correct. That may be all Countrywide did for many borrowers. But if that is all Mozilo was trying to do, he would have served many borrowers better by inviting them to stay overnight at his place. Giving someone a bad mortgage loan only puts someone in a home temporarily, and, left many borrowers worse off than before they ever heard of Countrywide.
Countrywide set up IndyMac (Independent National Mortgage) in 1985. The two thrifts split in 1997 and became competitors. In July 2008, IndyMac became the third largest bank to fail in the history of the United States, and in September 2008, $307 billion Washington Mutual (Sold to J.P. Morgan) became the largest to fail. The Federal Deposit Insurance Corporation (FDIC) is drawing on its $53 billion deposit-insurance fund.
Thrifts are regulated by the Office of Thrift Supervision (OTS). John Reich, head of the OTS, seemed to think U.S. Senator Charles E. Schumer bore some responsibility for IndyMac’s failure because the senator wrote a letter to the OTS with concerns about IndyMac’s solvency. He also made it public, which in my opinion is like yelling “Fire! ” in a crowded theater. In my mind, it also begged the question as to why Senator Schumer did not seem compelled to speak up earlier about predatory lending and problems at other institutions—say, Fannie Mae, Freddie Mac, or Countrywide. Senator Schumer countered that if the OTS had reigned in Indy Mac’s “poor and loose lending practices,” the thrift would not have failed, and that the regulator should “start doing its job.”42 Instead of acting like a sheriff of Mortgage Lenders, the Office of Thrift Supervision behaved like the sheriff of Nottingham.
The Office of Thrift Supervision had reason to intervene long before mortgage lenders started dropping like flies. If they did not read Berkshire Hathaway’s annual reports, they could read a report from the St. Louis Federal Reserve Bank. It noted in 2005 that all loans (subprime, Alt-A, and prime) have a higher default rate when the homeowner has little to lose—a low or zero down payment, for example. The report suggested that subprime loans with no down payment are an especially bad idea: “Serious delinquency (60 and 90 days) is especially sensitive to homeowner equity and origination.”43 Loosely translated, that meant that thrifts would have a much harder time getting paid back if they offered risky mortgage loans to people with no down payment and low credit scores. So where was the OTS when no (or low) down payment subprime loans combined with other risky features were being made?
As of 2008, although subprime loans are only $1.3 trillion (over 11-13 percent depending on how you define subprime) of the $11.5 trillion U.S. residential market, they are the most troubled. In May 2008, Standard & Poor’s announced that subprime loans originated in 2005-2007 looked awful, and loans made in 2007 were the worst of the bunch. Where was the OTS? Delinquencies for 2005 vintage subprime loans were 37.1 percent and had increased 2 percent from the previous month; 37.1 percent of 2006 vintage subprime loans were delinquent, a rise of 4 percent from March; 25.9 percent of subprime loans originated in 2007 were delinquent, a 6 percent jump from March to April 2008. The 2007 loans were “unseasoned” or young but were already at least a couple of months late in payments.4445 In the second quarter of 2008, a Mortgage Banking Association survey revealed that 9.2 percent of mortgages for single family to four-family homes were a month or more overdue or in foreclosure.46 It was the worst result in the 39-year history of the survey. In the month of August 2008, foreclosure filings in the U.S. rose to a record high of more than 303,000 properties as the continued drop in home prices, combined with tighter lending standards, made it harder for homeowners to refinance their mortgages, with and an estimated supply of unsold homes of 11 months.47
The direct and indirect costs to the U.S. taxpayer will be difficult to assess because of creative accounting that delays the recognition of the true problem. For example, banks and thrifts announced they were delaying their recognition of losses by allowing delinquencies of up to 180 days before taking a writedown on loans, and Fannie Mae and Freddie Mac said that in the past they wrote down loans when they were 90 days past due, but sometime in 2008 they decided to wait two years.48 On July 16, 2002, Alan Greenspan commented on the corporate shenanigans after the tech-bubble burst saying “infectious greed seemed to grip much of the business community,” and it was a once-in-a-generation frenzy of speculation.” 49 That was after the mini-frenzies of Drexel Burnham Lambert, Long-Term Capital Management, charged-off credit card receivables, manufactured housing loans, and more. Perhaps Alan Greenspan has found a way to accelerate the human lifecycle.
Fortunately for Berkshire Hathaway shareholders, Warren Buffett is the CEO. At year-end 1999, Berkshire Hathaway was Freddie Mac’s largest shareholder; it owned around 8.6 percent.50 Warren Buffett may prefer to hold onto stocks forever but only if he finds an investment that can go the distance with him. In his 2000 shareholder letter he wrote: “we sold nearly all of our Freddie Mac and Fannie Mae shares.”51 Warren later told me that Fannie Mae and Freddie Mac began emphasizing revenue targets of around 15 percent per year. He did not feel this double digit growth was sustainable just based on operating earnings alone. More than that, value investors are not impressed by revenues alone. Anyone can use leverage to inflate revenues.The quality of the revenues is paramount, since that is what will sustain profitability.
Berkshire Hathaway’s Clayton Homes seems to have avoided the contagion. I toured one of the manufactured homes at the Berkshire Hathaway annual meeting in 2006. Potential homeowners are not encouraged to buy a palace. Clayton Homes offers affordable housing at lending terms designed to help ensure the borrower will be able to pay off the loan. It is the chance for people to live a decent life, and there is dignity in being able to live within one’s means while bettering one’s circumstances. Most of Clayton’s earnings come not from its manufactured housing, but from its loan portfolio. Warren reports its results in the finance section of the Berkshire Hathaway annual report. At the end of 2007, Clayton had an “$11 billion loan portfolio, covering 300,000 borrowers.”52 Berkshire Hathaway provides the financing (instead of, say, an investment bank that would buy the loans, package them up, and resell them). In contrast to the rest of the mortgage loan market, “[d] elinquencies, foreclosures and losses” have stayed constant and the “Clayton portfolio is performing well.”53
Unfortunately, for many others in the global financial markets, false promises and broken dreams were part of many investment portfolios.The MADness spread across the globe as if it were a hypercontagious flu virus.
Chapter 6
Shell Games (Beware of Geeks Bearing Grifts)
I’ve looked at the prospectuses, and they are not easy to read. If you want to understand the deal you’d have to read around 750,000 pages of documents.
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��Warren Buffett to Janet Tavakoli,
January 10, 2008
On August 5, 2005, two days after Warren and I set up our meeting, Matthew (“Matt”) Goldstein, at the time a senior writer for TheStreet.com, wrote about problems with mortgage-backed CDOs. Eliot Spitzer, then New York Attorney General, had just sent Bear Stearns Co. (Bear Stearns) a subpoena. Hudson United, a small New Jersey bank, had tried to sell mortgage-backed CDOs it bought in 2002 back to Bear Stearns, the underwriter and seller of the CDOs. Hudson discovered its CDO investments were worth only a small fraction of the “market prices” that Bear Stearns had supplied Hudson up until it tried to sell them back.
In April 2005, I addressed the International Monetary Fund in Washington about the hidden risks of off-balance-sheet vehicles, securitizations, and the failure of the rating agencies to reflect these risks in their ratings. Sophisticated investors are baffled by the complexity; even multistrategy hedge funds such as Chicago-based Citadel had contacted me about securitizations. I told Goldstein that investors seemed to rely on ratings and rarely ask how the underlying assets are priced or whether they will get full price if they need to sell the investment: “There are huge transparency issues. In some cases, investors have been taken in by hype.”1
The U.S. Securities and Exchange Commission (SEC) launched a separate investigation into Bear Stearns’ CDO activities. Like the New York Attorney General’s office, it wanted to know if Bear Stearns had mispriced mortgage-backed CDOs and harmed investors. Bear Stearns subsequently disclosed in a regulatory filing that the SEC intended to recommend action. Many financial professionals believed Bear Stearns would be charged for alleged improper pricing of CDOs it had sold to both a bank and an institutional investor.2