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04.09

Understanding the Mess: Warren Buffett’s 2008 Letter to Berkshire Hathaway Shareholders

By Vin O'Neill

Berkshire Hathaway Chair Warren Buffet’s letter to shareholders in the company’s 2008 Annual report should be required reading for all Americans!

I say that, not as an owner of BRK (NYSE Symbol) stock, but as as ordinary citizen struggling to understand the causes and consequences of the financial meltdown that has engulfed the country — and the rest of the world — in recent months. Not only does the Buffett letter succinctly describe the 2008 performance of the companies he manages, but it includes compelling asides about public and private sector behaviors that set the stage for the worst economic crisis to befall the United States since — dare I say it — the Great Depression of the 1930s. Buffet’s narrative is written in clear, understandable language replete with poignant vignettes and humorous anecdotes that make it as entertaining as it is informative.

As many readers already know, Berkshire Hathaway is a diversified, 44 year-old Omaha Nebraska-based multi-national corporation, with significant stakes in energy distribution, financial services (including insurance and re-insurance), manufacturing, services and retail businesses. The above-average performance of all of these companies over the years — in good times and bad — is a tribute to the business skills and financial acumen of CEO Warren Buffett and the entire BRK team. But it is Buffett’s commentary on the failure of individuals and institutions charged with responsibility for managing the financial affairs of private businesses and government agencies that makes his letter so fascinating and informative. Here are some of Mr. Buffett’s most compelling insights:

On Contemporary Borrowing and Lending Practices — Buffet characterizes home mortgage lending practices as “atrocious.” Writing about these practices since the late 1990s, Buffet describes them as involving “borrowers who shouldn’t have borrowed being financed by lenders who shouldn’t have lent.” The need for meaningful down payments was frequently ignored. Impossible-to-meet monthly payments were often agreed to by borrowers who had nothing to lose. The resulting mortgages were then packaged (securitized) and sold by Wall Street firms to unsuspecting investors in the United States and throughout the world. “This chain of folly,” as Buffett puts it, “had to end badly and it did.”

On Mortgage-Backed Securities — According to Buffet, “the stupefying losses in mortgage related securities came, in large part, because of flawed, history-based models used by salesmen, ratings agencies and investors. These models were based on loss experiences over periods when home prices rose only moderately and speculation in houses was negligible. Many heretofore responsible organizations made this experience a yardstick for predicting future losses. “They blissfully ignored the fact that housing prices were skyrocketing, that lending practices were deteriorating and that many buyers were opting for houses they couldn’t afford. In short, “universe past” and “universe current” had very different characteristics — characteristics that lenders, government agencies and the media either failed to recognize or chose to ignore.

On Complex Financial Instruments — As Buffet points out, arcane derivatives and related accounting practices have dramatically increased the magnitude and complexity of risk in our financial system. They have made it almost impossible for investors and regulators to understand — let alone assess — the bewildering array of financial instruments developed and sold by America’s largest commercial and investment banks. They allowed Fannie Mae and Freddie Mac, for example, to engage in massive misstatements of earnings for years. Fannie and Freddie’s accounts were so indecipherable, that their Congressionally established regulator, the Office of Federal Housing Enterprise Oversight (OFHEO) totally missed the extent to which the two mortgage giants had been cooking their books.

On Transparency as a Deterrent — In Buffet’s opinion, improved transparency — a favorite remedy for politicians, regulators and pundits for averting financial train wrecks — won’t cure the problems that complex derivatives have created. He knows of no reporting mechanism that comes close to describing or measuring the risks inherent in complex portfolios of derivatives. “Auditors can’t audit them and regulators can’t regulate them,” the BRK CEO candidly asserts.

Buffet uses Fannie Mae and Freddie Mac as a dramatic case in point. These Federally sponsored organizations (FSOs) were created by Congress, which retains control over them and periodically dictates what they can and can’t do. In 1992, to order to provide additional oversight, Congress established the OFHEO and directed it to ensure that the two agencies were behaving themselves. With the stroke of a President’s pen, Fannie and Freddie became two of the most intensively regulated Federally chartered enterprises, as measured by manpower assigned to the task.

In June 2003, however, OFHEO delivered its 2002 annual report to the Congress — nine days after Freddie’s CEO and CFO had resigned in disgrace and its COO had been fired. No mention was made in the report — or the accompanying transmittal letter — of their departure. To make matters even worse, the report concluded that both Fannie and Freddie were “well managed and financially sound.”

On the Collapse of Bear Stearns — According to Buffett, the collapse of Bear Stearns in 2008 highlights “the counterparty problems that are embedded in derivative transactions.” As Tim Geithner, then the NY Federal Reserve Bank President, explained at the time, “the sudden discovery by Bear’s derivative counterparties that the important financial positions that they had put in place to protect themselves from financial risk were no longer operative would have triggered substantial dislocations in already fragile world financial markets.” Buffett’s translation: “The Fed stepped in to avoid a financial chain reaction of unpredictable financial magnitude.”

On Sleeping Around and the First Law of Corporate Survival — To better describe the complexity and consequences of financial derivatives, Buffet says that a frightening web of mutual dependence develops among financial institutions that are counterparties to derivatives contracts. Receivables and payables worth billions of dollars become concentrated in the hands of a few large dealers who are likely to be highly leveraged in other ways as well. Participants seeking to minimize inherent risks face the same problem as someone seeking to avoid contracting a venereal disease. “It’s not just who you sleep with, it’s also who they are sleeping with,” Buffett explains.

Ironically, “sleeping around” can be very useful for derivatives dealers deemed “too big to fail” because it helps to ensure government assistance if and when trouble develops. From this reality comes what Buffett humorously refers to as the “First Law of Corporate Survival.” For CEOs who pile on leverage by negotiating more and more complex derivatives contracts: “Modest incompetence simply won’t do; mind-boggling screw-ups are required to secure tax-payer funded bailouts.”

For More Information — These are just a few of Warren Buffett’s many extremely timely and very lucid anecdotal explanations for what went wrong in American and global financial markets over the past decade. All of the above and more are presented in the Berkshire Hathaway CEO’s letter to shareholders in the company’s 2008 annual report.

The letter takes up 23 pages in a 100 page report that is accessible online at www.berkshirehathaway.com/2008ar/2008ar.pdf.

Vin O'Neill is IEEE-USA's senior legislative representative for Career Policy Activities. Comments on this article may be submitted to todaysengineer@ieee.org.