Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street

by Janet M. Tavakoli

  Usually auction-rate bonds are bought and sold at a prespecified short period such as every 7 or 28 days.The interest rate is determined by buyers. If the auction fails, the interest rate goes up, usually to a rate specified in the documents. In some cases, the rate for unsold bonds rises as high as 20 percent (rates vary by bond), and the investor is left holding the old bonds. Auctions have rarely failed, so the market was in a panic. Some ARS were a bargain, but that meant municipalities were paying higher interest costs solely due to the confusion. For municipalities, that means taxpayers may pay higher taxes. Municipalities struggle to find a way to refinance into reasonable fixed rate debt in the dicey market, and as of June 2008, only 25 percent have refinanced. Local tax rates may increase to cover their problems.

  Banks and investment banks are hurting from lack of ready cash (liquidity) and would not buy back bonds since everyone’s confidence is so shaken that it is hard for the banks to trade them. Many investors were told by their bankers that the bank would always buy the bonds if an auction failed. Many investors were told these bonds were as safe as T-bills. Investors felt scammed. Some investors did not even see a prospectus until the auctions failed. Cash management accounts across the globe ranging from large corporate clients such as Google to small condominium associations could not sell their ARS.That may not be a crisis for Google, but customers like some condominium associations could not pay their bills and have to ask condo owners for more money.

  Even pension funds invested in these “AAA money market” securities. These assets are “guaranteed,” but many bond insurers are in trouble, so their “guarantee” is not worth anything. In some cases the underlying assets seem sound (so the “guarantee” does not matter), but in other cases there is a genuine risk of principal loss and the guarantee people depended on is worthless because “sophisticated” bond insurers guaranteed bad products manufactured by investment banks. Some but not all of the top underwriters (sellers) of municipal auction-rate securities included players in the subprime market: Citigroup, UBS, Morgan Stanley, Goldman Sachs, Bear Stearns, Merrill Lynch, Wachovia, Bank of America, JPMorgan Chase, Royal Bank of Canada, and Lehman Brothers, but few of the underwriters have clean hands when it comes to this new problem. Class action suits abounded. Banks and investment banks had undisclosed conflicts of interest with their retail customers, and seemed to pass on their liquidity problems to their customers.345 Many banks paid fines to settle claims with U.S. regulators and agreed to buy back ARS at full price (par) from retail clients and small businesses.67 The buy-back was unprecedented, but it did not include all customers. Larger customers are deemed to be sophisticated enough to know what they are doing, whether or not that is actually true.Those customers are usually left to work out their disputes themselves.8

  Many of the small accounts are handled by the “retail” side of banks and investment banks. Small investors thought their banks had a fiduciary responsibility to them.Yet, it now seems as if finance has become a game of “every man for himself.” In The Spanish Prisoner, Steve Martin plays a confidence man who advises:“Always do business as if the other person is trying to screw you because most likely they are, and if they are not, you can be pleasantly surprised.” In the current financial environment, it has come to that, because regulators failed to do their jobs.

  A certain and stable AAA rating is extremely valuable to any bond insurer. Investors pay for the guarantee believing it means uninterrupted cash flows and that belief means market liquidity. Even if interest rates in general rise and prices drop somewhat, the fact that one can count on cash flows makes reliable AAA bonds easier to price and trade. But if ratings are in doubt, the market freezes.

  In December 2007, seven bond insurers were rated AAA. Standard & Poor’s said underwriting quality for several of the bond insurers was high, but that was not true. The underwriting standards were actually naïve and bond insurers overly relied on faulty models. It was as if the rating agencies were daring the market to contradict them.910 So we did.

  William (“Bill”) Ackman, head of Pershing Square Capital Management, warned the market for years that bond insurers underestimated the risk of structured finance business. Whitney Tilson, a value investor, made presentations at conferences with Bill Ackman supporting his view. David Einhorn, founder of Greenlight Capital, also made public his concerns about the overrated bond insurers. Ackman sold short the holding companies of the two largest publicly traded bond insurers, MBIA and Ambac. In 2007 he announced that he would donate his personal gains to the Pershing Square Foundation, a charity.11 Pershing Square’s hedge funds stand to reap billions, which benefits Ackman in the long run.

  Ackman took the extraordinary step of using Internet-based Open Source to post the subprime related holdings of Ambac and MBIA. He, in turn, obtained the positions from an investment bank he declined to name. Usually, outing positions is not the done thing, but in this case I heartily approve. Ackman took flack because he put out high loss numbers for the bond insurers. He tried to make his opinion transparent, but the spread sheet is a black hole of time-sucking minutiae.

  Armed with Ackman’s publicly available information, I simplified the analysis. According to Ackman’s spreadsheet, many of the CDO positions held by Ambac and MBIA are horrifying. Most bond insurers had CDO-squared positions, with inner CDOs including constellation deals and other CDO-squareds.12 On January 3, 2008, I wrote my clients that most of the bond insurers deserved much lower ratings, and all of the major bond insurers, including Ambac and MBIA—the largest insurers of municipal bonds—deserved to lose their AAA ratings.13 This was bad news for the municipal bond market. Ambac and MBIA insure around $2 trillion in securities, and FGIC insures another $315 billion. Ambac and MBIA insure most of the public finance market including $1 trillion of U.S. “guaranteed” municipal bonds. What’s more, investment banks that bought protection from bond insurers already had billions in mark-to-market losses. Investment banks would have to take losses of many billions more.

  In early January 2008, I told CNBC that the bond insurers are in deep trouble: “They did the financial equivalent of insuring drunk drivers with bad driving records at the same prices as they would insure teetotalers with good driving records.”14 Management will have to go and there will have to be a restructuring. MBIA and Ambac need capital and there is a “crisis of confidence in that management.”15 CNBC’s Becky Quick asked why people were surprised by something that I had been predicting for a long time. Jack Caouette, then vice chairman of MBIA, had written a blurb for my 2003 book on securitization saying caveat emptor—yet, the bond insurers had been careless.

  CNBC contributor David Kotok, chief investment officer of Cumberland Advisors, an investor in municipal bonds (among other things), did not agree with me. He said there are “seven triple-A municipal bond insurers,”16 and thought this was an opportunity. He said the municipal bond insurance would be fine. He seemed unaware of the ratings peril.

  On January 10, 2008, MBIA paid 14 percent in interest to raise $1 billion in capital; the 10-year U.S. treasury yield was less than 4 percent.17 The market no longer seemed to believe that MBIA was AAA rated.Warren laughed as he asked me:“Did you ever think you would see a triple-A raise money at 14 percent [with treasury rates so low]?”

  In January of 2008, Eric Danillo, the New York insurance regulator, called a meeting of investment banks to discuss the way forward for the monoline insurers. Based on market feedback, Danillo knew the bond insurers needed capital, and cash-strapped investment banks did not want to cooperate. Danillo, however, had more to say.

  A key feature of credit derivatives is that fraud is not a defense against payment. That means that if a default occurs, both sides settle up, and if there is a problem, allegations of fraud can be litigated later. Bond insurers had done a particular type of credit derivative contract called pay-as-you-go. Danillo pointed out it looks like an insurance contract, and he is an insurance regulator. According to one banker, Danillo brought u
p the fact that there is an extraordinary amount of fraud associated with mortgage loans backing the deals guaranteed by the bond insurers. Danillo suggested these were unusual circumstances.

  The smarter investment banks were alarmed. If push came to shove, bond insurers might use fraud as an excuse to avoid payments, or the bond insurers might try to nullify contracts.That would mean billions of dollars of losses for the investment banks.

  On January 25, 2008, I told CNBC’s Joe Kernen that the underwriters (not the rating agencies) are responsible for doing due diligence, and Danillo raised the issue of insurance and fraud. The investment banks might have to take the loans back on balance sheet, and they took Danillo very seriously.

  Charlie Gasparino asserted the rating agencies are the “culprit.”18 I responded that blaming rating agencies without mentioning the role of the underwriters is incorrect, since investment banks buy and sell the securities and are obliged to do due diligence.

  Dinallo, Gasparino said, “is probably hiding under his desk,” and that “what he did is completely irresponsible,” referring to the bailout plan. He added that Dinallo “has a little explaining to do.”19 But Matt Fabian of Municipal Market Advisors observed that investment banks and rating agency interests are aligned, and “the bailout plan is a pretty obvious one.”20 Fabian said the investment banks must have a problem coming up with the money.

  The investment banks struggled to hold off a wave of write-downs and were dismayed by the prospect of coming up with money to help the bond insurers.The banks were worried that the bond insurers would figure out a way to get out of the contracts and all of that risk would come right back on the investment banks’ balance sheets.

  By the end of June 2008, MBIA and Ambac lost their AAA ratings and three other bond insurers had been downgraded from AAA to junk (below investment grade).21 Some bond insurers sued, others investigated options to nullify contracts. But they left it too late. The bond insurers have been damaged and investment bank took more losses as they took risk back on their balance sheets. The fights will go on for years. Eric Dinallo is not the one with a little explaining to do.

  Strong municipalities do not need guarantees from bond insurers. Besides, the guarantees are worse than worthless. In many cases, municipal bonds can get a strong investment grade rating on their own merits. During the summer of 2008, municipalities worthy of a single-A rating on their own merits—and many merited higher ratings—found their bonds would trade more easily without the guarantee. As of September 2008, the municipal bond market remained in a state of flux as Moody’s announced that in about a month hence it would change the way it assigns ratings to tax-exempt borrowers. This would result in higher ratings for many municipalities, but of course, this is not an actual upgrade in quality; it is merely a relabeling.22 By the time this book is published there may be more clarity and consistency in municipal bond ratings, but until there is, the confusion may make it more difficult for municipalities to predict their borrowing costs.

  When we first met, I told Warren that I am an avid Benjamin Franklin fan and have read his short autobiography several times.Warren looked at me as if I were pulling his leg. He handed me a copy of Poor Charlie’s Almanack—Vice-Chairman of Berkshire Hathaway and longtime friend Charlie Munger’s self-styled finance homage to Franklin. Munger is also a great admirer of Benjamin Franklin, the statesman, philosopher, author, founder of the first North American library, publisher and inventor. Those are reasons enough for admiration, but Franklin was also the father of the North American insurance business, a lynchpin of Berkshire Hathaway’s success.

  Inspired to take action after a 1730 fire destroyed the shops on Fishbourn’s wharf in Philadelphia, Benjamin Franklin wrote a guide on “different accidents and carelessnesses by which houses are set on fire . . . and means of avoiding them.”23 Shortly thereafter, Benjamin Franklin started Union Fire Company, the first volunteer fire department in North America. Even more important to the future success of the as-yet-unborn Warren Buffett and Charlie Munger, Franklin also started the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire, the first successful (Charles Town’s earlier effort was unsuccessful) fire insurance organization in North America. The first board meeting was held in 1752, the year the colonies switched from the Julian calendar to the Gregorian calendar, two years before the British colonies sent representatives to the Albany Congress, and 24 years before those colonies declared independence from Britain. Franklin noted that when it came to fires: “An ounce of prevention is worth a pound of cure,”24 but for what one cannot prevent, insurance helps provide the pound of cure.

  Run properly, underwriting risk is a money-making machine that makes a commercial bank look like a child’s piggy bank in comparison. A successful insurance operation generates float, premiums received before losses are paid—sometimes years or decades before losses, if any, are paid. An insurance company does not technically own its float, called reserves, but it has the use of the reserves for investment purposes. A rising tide lifts all boats, and an increasing stream of well-invested float lifts all returns.

  Americans love to buy insurance. My cyber-friend, Andrew Tobias, wrote a classic book on the insurance industry, The Invisible Bankers, more than a quarter of a century ago. Some regulations have changed, but the fundamental principles of making money in the insurance business have remained the same.Tobias cites a Playboy survey in which 91 percent of the men thought a car is a necessity—and it is difficult to use that necessity without car insurance. 88 percent of the men thought health insurance was a necessity. Even though only 60 percent of the men surveyed were married, 79 percent of the men responding thought that life insurance was a necessity, not a luxury. Only 16 percent of the men thought that dining out every week was a necessity.25

  So the question isn’t whether or not Americans will buy insurance, but rather, how much will they buy and from whom?

  The competence of the insurer is crucial, because Mr. Market’s manic depressive cousin prices insurance risk. The magic trick in the insurance business is to avoid volume just for the sake of volume.

  Auditors do not seem competent to evaluate reported reserves, since anyone can create huge reserves by underwriting bad business. How did that work out for MBIA and Ambac? The rating agencies seem even worse than the auditors. When rating agencies told Berkshire Hathaway they liked to see an increasing revenue stream in AAA insurance companies, Warren told me he said he would never let revenues be his target. Anyone can increase revenues by underwriting risk at the wrong price. In a shareholder letter, he wrote:

  Where “earnings” can be created by the stroke of a pen, the dishonest will gather.26

  Warren’s insurance businesses only underwrite insurance risks when market prices are favorable. Insurance success depends on pricing premiums so that premiums exceed losses and expenses. When prices aren’t favorable, Berkshire Hathaway ignores Mr. Market’s cousin. But when it can underwrite risk at premium prices, Berkshire Hathaway’s insurance businesses participate massively.

  Simonides, a Greek poet and philosopher, was among a handful of survivors after an earthquake destroyed the great hall of a palace where he attended a party. The crushed victims’ bodies were so badly disfigured that grieving relatives could not identify the corpses for burial. Simonides recalled each of the two hundred guests by name and remembered each guest’s exact location in the hall, allowing the mourners to separate and identify the bodies of their friends and relatives. He hadn’t anticipated the earthquake. His mental picture was formed before the disaster.

  Simonides is not around anymore, but fortunately for Berkshire Hathaway, it has Ajit Jain to tend to Geico and General Reinsurance, Berkshire Hathaway’s large insurance company holdings. He joined Berkshire Hathaway in 1986, and built its reinsurance business from scratch.The reinsurance business may be even better than primary insurance. Jain tries to price premiums so that no matter who verifies the claims, the insurance business remains
profitable.

  For the right price, Berkshire Hathaway’s reinsurance companies underwrite the excess risk other insurance companies are eager to shed, reducing their maximum possible loss. Insurance companies sometimes need to expand capacity, exit an insurance business, or protect themselves against rare catastrophic losses, and they are often willing to pay up to meet these needs. For nothing more than a promise, Berkshire Hathaway receives large premium payments in advance. Losses and loss payments are usually delayed far into the future. In the hands of skilled investors like Buffett and Munger, those payments compound to levels that can far exceed any potential future payments.

  The super catastrophe or super-cat business may be even better than the reinsurance business, but no one really knows. Berkshire Hathaway is also in this business, and reaps very high upfront premiums. But in a horrific year, the super-cat business will take a huge hit.When it comes, the compounding of the cash has to be great enough to cover the losses.

  In December 2007, Ajit Jain set up Berkshire Hathaway Assurance to take advantage of opportunities in municipal bond insurance. In an unprecedented move, New York insurance regulators proposed the idea to Berkshire Hathaway and quickly cut through red tape. In late January 2008, Jonathan Stempel at Reuters asked me if Warren Buffett planned to reinsure the monoline’s structured finance positions. I stopped myself from laughing, and suggested he check his facts directly with Berkshire Hathaway.