Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street
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46 Alan Sloan and Roddy Boyd, “The Lehman Lesson,” Fortune, 13 September 2008.
47 Jason Kelly and Jonathan Keehner, “Lehman’s Survival Hinges on Fuld’s Reluctant Sale of Fund Unit,” Bloomberg News, 11 September 2008.
48 Carrick Mollenkamp, Susanne Craig, Sernea Ng and Aaron Lucchetti, “Lehman Files for Bankruptcy, Merrill Sold, AIG Seeks Cash,” Wall Street Journal, 16 September 2008. Lehman filed for protection under Chapter 11 of the U.S. Bankruptcy Code. This is an attempt to ensure an orderly liquidation. Lehman said the filing did not include broker-dealer subsidiaries (or other LBHI subsidiaries or Neuberger Berman Holdings LLC). Neuberger Berman is operating as usual. Its assets are segregated from Lehman Brothers.
49 Bank of America press release, “Bank of America Buys Merrill Lynch Creating Unique Financial Services Firm,” 15 September 2008. Bank of America will exchange .8595 shares of Bank of America common stock for one Merrill Lynch common share.
50 Nicholas Varchaver, “What Warren Thinks...” Fortune, 28 April 2008, p. 59.
51 Bradley Keoun, “Accounting Rule Defying Common Sense,” Bloomberg News, 8 June 2008. If accounting weren’t bizarre enough, as of January 1, 2008, firms can record an increase in revenue when the price of their own bonds declines, and this “revenue” has been used to net off against losses, so the losses reported by investment banks and monoline insurance companies look less damaging than they would have otherwise appeared.
52 Yalman Onaran,“Banks Keep $35 Billion Markdown Off Income Statements,” Bloomberg News, 19 May 2008. By May 2008, Bloomberg estimated that tens of billions more in writedowns would have shown up on balance sheets if the losses had not been offset by the decline in the price of investment banks’ debt. The theory is that if the bonds are redeemed at a lower price, it is a net benefit to the company. That is only true, however if a firm has the ability to buy the bonds due to an increase in revenues or other means without strain in some other area. If you want to report the maximum revenues due to a decline in the value or your debt, go into bankruptcy. Now your debt will only be worth your recovery value, if any.
53 Warren Buffett has long been a critic of pension rate assumptions, and he made similar comments on CNBC March 3, 2008. Even pension fund accounting can be very misleading. Often rates used by pension funds are mandated, and Warren thinks they are too high. Berkshire Hathaway owns some public utilities, and although he would like to use a lower rate for pension fund assumptions, the lowest rate is 6.5 percent. At least that is lower than the 8 percent rate much of the rest of the financial world uses.The rate difference may not seem that much at first glance, but for long term funds like pension funds, it is an enormous difference. For example, $100,000 compounded at an annual rate of 6.5 percent for 30 years is $661,436, but compounded at 8 percent, it is $1,006,265. If Warren Buffett thinks 6.5 percent is too much to promise—meaning pension funds are not kicking in enough to make their future payments—do you think the rest of the world will do a better job using an assumed rate of 8 percent?
54 Berkshire Hathaway 1990 Annual Report 3.
55 Josh Hamilton and Erik Holm, “Buffett’s Berkshire Says Net Declines on Insurance, Derivatives,” Bloomberg News, 3 May 2008.
56 Berkshire Hathaway 2007 Annual Report, 16.
57 Ibid.
Chapter 11: Bond Insurance Burns Main Street
1 Jody Shenn, “FGIC Sees No Need to Honor Agreement with IKB, Calyon,” Bloomberg News, 26 March 2008. On March 12, FGIC, a bond insurer, filed a lawsuit in the New York Supreme Court against Calyon, a French investment bank, and IKB, the German-owned state bank. Calyon had arranged a deal for IKB, and FGIC was nullifying a $1.9 billion guarantee on a portfolio of mortgage-backed securities. At the start of 2008, FGIC was still rated AAA, but that day Fitch downgraded the bond insurer to BBB, the lowest investment grade rating. It now struggles for survival with a junk rating.
2 Traditionally, the main line of business of monoline insurance companies, or monolines, was to provide bond insurance. Bond insurers (or monolines) provided credit wraps, which are financial guarantees, and under New York law, home of the largest U.S. investment banks, monolines are the only entities allowed to provide financial guarantees. Many of the bond insurers bought subprime-related CDOs including, in some cases, risky CDO-squared products.
3 Michael McDonald,“Auction-Bond Failures Deplete New Hampshire Fund,” Bloomberg News, 17 March 2008.
4 Darrell Preston, “Banks Say Auction-Rate Investors Can’t Have Money,” Bloomberg News, 6 June, 2008.
5 Michael McDonald, “UBS E-Mails Show Conflicts With Auction-Rate Customers in Suit,” Bloomberg News, 27 June 2008.
6 Karen Freifield and Michael McDonald, “Morgan, JPMorgan Settle Auction-Rate Probe, Pay Fines,” Bloomberg News, 14 August 2008.
7 David Scheer and Karen Freifeld, “Citigroup to Unfreeze $19.5 Billion of Auction Debt,” Bloomberg News, 7 August 2008. Closed end funds issued preferred auction-rate securities which were not included in these buy-back settlements.
8 Robert Frank and Liz Rappaport, “Big Boys Face ‘Auction’ Monster Alone,” Wall Street Journal, 29 August 2008.
9 Moody’s Investors Service, Global Credit Research Announcement:, Moody’s Announces Rating Actions on Financial Guarantors, 14 December 2007. Moody’s had a stable outlook when it affirmed the ratings of Ambac (Aaa). Fitch placed the AAA ratings of Ambac, MBIA, and FGIC on review for possible downgrade. XL Capital Assurance was put under review, and Fitch said it needed to raise $2 billion. Fitch indicated Ambac and MBIA would be cut to AA+.
10 Aaron Lucchetti, “CDO Battles: Royal Pain Over Who Gets What,” Wall Street Journal, 17 December 2007. Analysts seemed to have just noticed details like unwind triggers, including market value triggers for shaky structured investment vehicles (SIVs) that issued short-term debt to fund risky longer-term higher yielding assets—similar to Countrywide’s problem in August, but the Fed was not bailing out the structured investment vehicles. For example, in November 2007, MBIA Inc., the largest bond insurer, sold assets to bond-holders of its Hudson Thames Capital SIV. It wound down from $2 billion to $400 million after announcing that it had failed to find investors since August in the asset-backed commercial debt issued by this vehicle. MBIA waged a legal battle with Deutsche Bank, Wachovia Corp., and UBS over the cash flows of Sagittarius CDO I, a constellation CDO. In November 2007, it triggered an event of default leading to an unwind. MBIA seemed to think it had a traditional deal entitling it to the remaining cash flows—did it ever read a prospectus? LaCrosse Financial Products LLC, an MBIA affiliate, had done a credit derivatives transaction on the seniormost tranche. The unnecessarily complicated prospectus language made it difficult for the trustee to determine which investor had payment priority. As was typical of these deals, there is an interest-only class. If the deal went into liquidation as other CDOs had done, the fight could be over less cash. On December 17, 2007, I told the Wall Street Journal:“If you liquidate a lot of assets at once, you don’t always get the best price.” More than that, the structure disadvantaged naïve senior note-holders. The equity holder seemed to benefit at their expense. The equity is like the blow and burn in the arms trade, the detonator of whatever you are pedaling. It marks you as a pro, since you can profit even when a deal goes bad, and this CDO was scheduled for a meltdown the day it closed. I pitied any investor in the AAA or AA rated tranches of the CDO.
11 “Shorting Bond Insurers for Charity,” New York Times DealBook, dealbook.blogs .nytimes.com, 28 November 2007.
12 Janet Tavakoli, “Dicey Deals Done Dirt Cheap,” Tavakoli Structured Finance, Inc., 3 January 2008. No model is required to grasp the problem. In December 2007, Standard & Poor’s stress test estimated that monoline financial guarantors have $10.7 billion in potential aggregate losses, but S&P’s stress case for losses was below my base case. S&P assumed stress case losses of only 15.5 percent. For 2006 vintage first lien subprime loans, I used a 30 percent default rate and a 70 percent l
oss rate. My net base case losses were 21 percent. Moody’s base case used an 11 percent loss assumption for 2006 vintage first lien subprime loans. Moody’s stress case loss of 19 percent for subprime loans was near my base case of 21 percent and well below my stress case of 30 percent for 2006 originated subprime loans. To achieve the triple-A (Aaa) rating, Moody’s looks for an insurer with capital equal to 130 percent times base case losses and 100 percent times stress case losses. Using my base case assumptions for subprime losses and Moody’s base case capital criteria, five of the seven triple-A-rated financial guarantors did not merit their high ratings. In the late 1990s, when CapMAC Holdings Inc., was in trouble (CapMAC merged with MBIA in 1998), it was given a minimal grace period to raise capital before losing its top rating; there was no kidding around. But now the rating agencies reeked of desperation. Several bond insurers were given more than a month to raise more money. Moody’s had nearly 90,000 politically charged public finance deals on negative watch for downgrades—due to the potential downgrades of two of the smaller bond insurers (FGIC and XL) alone.
13 Ibid. In December 2007, Standard & Poor’s affirmed the ratings for Ambac Assurance Corp, CFIG’s entities, MBIA Insurance Corp., and Security Capital Assurance (XL Capital Assurance Inc. and XL Financial Assurance Ltd. (XL)) with a negative outlook. Financial Guaranty Insurance Corporation (FGIC) was rated AAA but was on negative watch. ACA Financial Guaranty Corp. had been recently downgraded from A to CCC with CreditWatch Developing, but the downgrade was long overdue. Moody’s put the triple-A ratings of FGIC and XL on review for possible downgrade. It affirmed the triple-A ratings of MBIA and CIFG, but with a negative outlook. Financial Guaranty Insurance Corporation (FGIC), MBIA Inc. (MBIA) and Security Capital Assurance (XL Capital Assurance Inc. and XL Financial Assurance Ltd. (XL) merited immediate multi-notch—in some cases multigrade—downgrades. Ambac Financial Group Inc. (Ambac) and CIFG were stronger yet not sufficiently strong to merit the triple-A rating, and only Financial Security Assurance Inc. (FSA), and Assured Guaranty Corp. (AGC) seemed eligible to retain a “triple-A” rating (based on subprime exposure). Unfortunately, the latter two were relatively small (with FSA being the larger) so the problems of the larger players had a huge market impact. Stress test scenarios were even worse. If one considered that an increase in capital cushion might also be required to support other business lines, the situation was desperate. Canadian Imperial Bank of Commerce (CIBC) had already announced $2 billion in write-downs, and Merrill had billions more related to ACA.
14 Becky Quick, Janet Tavakoli, David Kotok, “Backing up the Bond,” CNBC, January 7, 2008 (video segment).
15 Ibid.
16 Ibid.
17 Saskia Scholtes, “MBIA in $1bn Deal to Retain Rating” Financial Times, 11 January 2008.
18 Janet Tavakoli, Matthew Fabian, Charles Gasparino, “Bond Insurance: The Bigger Problem,” Squawk Box, CNBC, 25 January 2008.
19 Ibid.
20 Ibid.
21 Liz Rappaport and Serena Ng, “Bond Insurers Inflict Further Pain on Market,” Wall Street Journal, 21 June 2008. By the end of June 2008, formerly triple-A bond insurers FGIC, CFIG and XL were all below investment grade, and MBIA and Ambac lost their triple-A ratings. They were already downgraded two notches to AA by S&P and were under review for a further downgrade. Bond insurers had several lawsuits or other investigations underway challenging the validity of the credit derivatives contracts related to subprime backed securitizations with their investment banking counterparties.
22 Jeremy R. Cooke and Darrell Preston, “Moody’s Loses Credibility; Muni Ranks Mean No Savings,” Bloomberg News, 11 September 2008.
23 Benjamin Franklin, The Autobiography of Benjamin Franklin (1868; reprint, Mineola, N.Y.: Dover, 1996), 75, 81, 82.
24 “The Quotable Franklin,” The Electric Ben Franklin, http://www.ushistory.org/franklin/quotable/index.htm.
25 Andrew Tobias, The Invisible Bankers (New York: Washington Square Press, 1982), 15, 94.
26 Berkshire Hathaway 1987 Annual Report. The chairman’s letter containing this quote is posted on the Berkshire Hathaway Web site (www.berkshirehathaway.com/letters) without page numbers.
27 Jonathan Stempel, “Buffett Poised to Cash in on Bond Insurer Woes,” Reuters .com, 30 January 2008.
28 Ibid.
29 Martin Z. Braun, “Auction-Bond Failures Roil Munis, Pushing Bond Rates Up,” Bloomberg News, 13 February 2008. The tender option bond market, which relies on periodic auctions to set the reinvestment yield, failed the second week in February. Bonds sold by the Port Authority of New York and New Jersey could not attract bidders at reasonable rates, and yields popped up to 20 percent from 4.3 percent the previous week.The U.S.Treasury’s 10-year bond yields traded at less than 3.7 percent, yet the supposedly triple-A-rated tender option bonds traded at a yield of 20 percent.
30 John Glover, “Auction-Rate Bonds Lure Investors with 20% Interest,” Bloomberg News, 18 February 2008.
31 Vikas Bajaj, “Buffett Offers to Reinsure Bonds,” New York Times, 12 February 2008. On February 6, 2008, Mr. Buffett offered a better deal, but it was a package deal for around $800 billion in municipal bonds. The bond insurers had to first accept the offer.Then they would have 30 days to shop the offer. If they found a better deal, they would pay a 1.5 percent kill fee to Berkshire Hathaway Assurance. He proposed to reinsure the bonds for a premium equal to 1.5 times the remaining premium left over the life of the bond, which is the original premium less the amount proportionally earned up until then. This solution would allow $800 billion of municipal bonds to keep a solid and dependable AAA rating. The solution was elegant. Even if the monolines lost their AAA ratings, the municipal bond markets would maintain AAA ratings with the assurance of Berkshire Hathaway Assurance’s AAA backstop. The financial guarantors would release regulatory capital equal to the premium they would pay Berkshire Hathaway Assurance, so they could continue doing business.The monolines turned him down.
32 Warren Buffett made this comment about the 206 transactions during a March 3, 2008, interview on CNBC.
Chapter 12: Money, Money, Money (Warren and Washington)
1 Erik Kirschbaum, “Buffett Sees ‘Long, Deep’ U.S. Recession,” Reuters.com, 24 May 2008.
2 Benjamin Graham, The Intelligent Investor (New York: Harper & Row, 1973), 101.
3 Eliot Spitzer, “Predatory Lenders’ Partner in Crime,” Washington Post, 14 February 2008.
4 Alan Feuer and Ian Urbina, “Affidavit: Client 9 and Room 871,” New York Times, 11 March 2008.
5 Eliot Spitzer, “Full Text of Spitzer Resignation,” New York Times, 12 March 2008.
6 David Koceiniewski and Danny Hakim, “Felled by Scandal, Spitzer Says Focus Is on His Family,” NewYork Times, 13 March 2008.
7 “Testimony, Ben S. Bernanke, Developments in the financial markets: Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, April 3, 2008, Federal Reserve press release. See http://www.federalreserve.gov/newsevents/testimony/bernanke20080403a.htm.
8 Alistair Barr, “Bear Portfolio Worth $28.9 Billion, Fed Says,” Market Watch, 3 July 2008.
9 Jim Rogers has made these comments on Bloomberg TV and CNBC several times in the past several months. Rogers made these particular comments from Singapore during a segment that aired on Bloomberg Television June 5, 2008.
10 Josh P. Hamilton and Erik Holm, “Buffett Castigates Wall Street, Bankers on Blunders,” Bloomberg News, 5 May 2008.
11 Kara Scannell, “SEC Role Is Scrutinized in Light of Bear Woes” Wall Street Journal, 27 March 2008.
12 Jonathan Stempel, Buffett Backs Fed Over Bear Stearns,” Reuters.com, 4 May 2008.
13 “Testimony, Ben S. Bernanke, Developments in the financial markets, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, April 3, 2008.
14 Jeremy Grantham, “Immoral Hazard,” GMO Quarterly Letter, April 2008.
15 Bloomberg News, “Two Fed Bank Presidents Warn About Lending to Sec
urities Firms,” NewYork Times, 6 June, 2008.
16 Jeffrey M. Lacker “Financial Stability and Central Banks,” speech presented by the president of the Federal Reserve Bank of Richmond, London, June 5, 2008.
17 Craig Torres, “Fed ‘Rogue Operation’ Spurs Further Bailout Calls,” Bloomberg News, 2 May 2008.
18 Krishna Guha, Saskia Scholtes and James Politi, “Saviours of the Suburbs,” Financial Times, 4 June 2008.
19 Warren Buffett during a televised CNBC interview with Becky Quick, Squawk Box, 22 August, 2008.
20 Dawn Kopecki, “Fannie, Freddie ‘Insolvent’ After Losses, Poole Says,” Bloomberg News, 10 July 2008.
21 Jody Shenn and James Tyson, “Fannie Mae, Freddie Mac Portfolio Caps Will Be Lifted,” Bloomberg News, 27 February 2008.
22 Nick Timiraos, “U.S.-Backed Mortgage Program Fuels Risks: FHA Struggles to Eliminate Loans for Zero Down,” Wall Street Journal, 24 June 2008.
23 Sannon D. Harrinton and Abigail Moses, “Company Bond Risk Rises as Bank Concerns Offset Fannie Rally,” Bloomberg News, 14 July 2008.
24 David M. Walker, Saving Our Future Requires Tough Choices Today, a presentation given by the former Comptroller General as part of the Fiscal Wake-Up Tour at Haas School of Business, University of California-Berkeley, Berkeley, California, March 5, 2008, U.S. Government Accountability Office document GAO-08-583CG.
25 Creadon, Patrick, dir. I.O.U.S.A. Documentary. Agora Entertainment, 2008. After the August 21, 2008 debut, Warren Buffett, CEO of Berkshire Hathaway; William Niskanen, Chairman of the CATO Institute; Bill Novelli, CEO of AARP; Pete Peterson, Senior Chairman of The Blackstone Group and Chairman of the Peter G. Peterson Foundation; and Dave Walker, President & CEO of the Peter G. Peterson Foundation and former U.S. Comptroller General participated in a live discussion broadcast to the movie viewers.