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Commentary

Buffett's Annual Letter 2008

Warren Buffet’s Annual Report is here. Always fun to read, and interesting titbits emerge.

This has been the worst absolute year for Berkshire Hathaway since 1965, a 9.6% decline in per-share Book Value. The stock, meanwhile, sits in at $74,000 – about half its high about a year back.

Commentary about the current housing crisis often ignores the crucial fact that most foreclosures do
not occur because a house is worth less than its mortgage (so-called “upside-down” loans). Rather, foreclosures
take place because borrowers can’t pay the monthly payment that they agreed to pay. Homeowners who have
made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away
from a primary residence simply because its value today is less than the mortgage. Instead, they walk when they
can’t make the monthly payments.

Interesting. The word “primary residence” is important here – as speculators were more likely to have overleveraged on their second or even third homes. They usually form a small percentage, but in the age of easy money, everyone is a speculator except those who aren’t counted because they’re so damn stupid. (not anymore, but they did look stupid then. And they’re not counted today either, because they’re the smart minority. Who pay for the stupid.)

After homeowners fall behind and can’t meet their monthly payments, what if the mortgage owner called and said “Listen, I’ll cut you a little slack. Let me modify your mortgage so I take a little value off, and give you a lower interest rate, so you can make the monthly figure”?

Turns out the answer to that question isn’t an emphatic yes. (In that link, FDIC had a program to help modify IndyMac loans that were delinquent for 60 days or more. 50K qualified, 15K were mailed mod offers, and after two months, only 3,500 said ok – a figure we don’t know is much higher or much lower than the mod-rate without this “program”. This line is important:

if you apply the program to borrowers who are, as a class, more likely to be able to afford their mortgages anyway, you do get more successful modifications. But something tells me that’s not quite what we all had in mind.

That is perhaps what Buffett had in mind though, as he says:

The present housing debacle should teach home buyers, lenders, brokers and government some simple
lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment
of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income
should be carefully verified.

Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective.
Keeping them in their homes should be the ambition.

on Bond Insurance, that Berkshire writes:

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different
loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different.

To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its
bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York
banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before
long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it
was apparent to all that New York’s citizens and businesses would have experienced widespread and severe
financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belttightening,
tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire
would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required
contribution would most certainly have been substantial.

Local governments are going to face far tougher fiscal problems in the future than they have to date.
The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities
and states were surely horrified when they inspected the status of their funding at yearend 2008. The gap between
assets and a realistic actuarial valuation of present liabilities is simply staggering.

When faced with large revenue shortfalls, communities that have all of their bonds insured will be
more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured
bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be
highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that
others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local
citizens in the form of major tax increases over pain to a far-away bond insurer?

Insuring tax-exempts, therefore, has the look today of a dangerous business – one with similarities, in
fact, to the insuring of natural catastrophes. In both cases, a string of loss-free years can be followed by a
devastating experience that more than wipes out all earlier profits. We will try, therefore, to proceed carefully in
this business, eschewing many classes of bonds that other monolines regularly embrace.

There are well written comments on Derivatives, the idea behind Freddie Mac and Fannie Mae, how a huge regulator was created just for their oversight and how they managed to confuse the hell out of the regulators. Apart from that, Buffett defends the US Government-supported buyout of Bear Stearns by JP Morgan; and that derivatives are best done when you’re too big to fail – as indeed, Berkshire seems to have become too.

It’s written second level bond insurance – if the monolines fail, Berkshire will be reasonably crippled, it seems. It has a $37 billion dollar put write, for which they have recognised a $5 billion mark to market loss ($10 bn MTM less the 4.9 billion premium received). And that was when the index was at 900 – it’s at 700 now, and europe looks in worse shape. Buffett reiterates that he has to post no collateral for the European put option, and that it’s unlikely to go to zero. I give you Japan – 20 years, and 66% loss and staying there. Even 50% of the 37 billion is a good big figure. As for the collateral – what if regulation changes to force collateral for every contract, otherwise it’s illegal?

(Just like saying a houseowner should be 10% down – a contract should be marked with collateral)

But overall, a fascinating annual report. I think Berkshire will lose a lot of money this year. And a truckload of stock value has already gone, and more likely to go. But they will survive, even without government support. That’s more than I can say of nearly everyone else their size.

  • Anonymous says:

    >deepak

    your writing smacks of buffett bashing for the sake of it without proper analysis

    i am not sure you have understood the derivatives explaination. in addittion the example of japan does not make sense. a 66% drop happened from very high valuation levels and 15 yr recession
    the puts have not been written at such high valuations and even a 50% drop results in cost of capital of 6.8 % (the example buffett has used)

    why do you think berskhire will lose a lot if monolines go down. berskhire is the second or third in line and has its liability capped in those cases

    i would suggest you read the berkshire Annual reports to get an idea of how well capitalized the company is.

  • Deepak Shenoy says:

    >Heck, Japan didn't make sense to anyone in 1991. If you told someone in Japan, that the US market had done nothing for the upside between 1966 and 1981, you would have heard exactly what you said – you can't compare Japan to the US etc.

    Berkshire has written puts around the 1400 level on the S&P, looking back at when the contracts were initially written/announced. I'm not saying the US will NOT recover – but given the recession is at least as bad as the one in Japan in the 90s, there's a chance markets stay really low.

    Monoline stress should hit around $10 bn and there's a primary write of $3.7bn…not huge, but crippling (because by then, Berkshire's credit rating will have been hit)

    Berkshire isn't going down; but the capital it has today can be seriously stressed through many factors – insurance events (which Buffett notes he has been incredibly lucky about), regulation, insolvency of invested companies and so on.

    CDS spreads on BRK have widened to 450 basis points, though we'll have to see that sustain over a few months to believe it.

    Buffetts example of 6.2% comes close to the amount he would actually get the money at – 6.8% to 9.2% on 15 to 20 years, 37bn dollar 50% loss with 4.9bn premium. Not big, though it doesn't include currency risk (liability could be much higher) or regulation risk. Hey, or investment risk.

    Berkshire evoke such strong defenses. I always get surprised in belief about Buffett – hey, he's just human, and it's all right to make a few mistakes! But no, how could I, a blogger for heaven's sake, suggest such a thing?

  • abhikush says:

    >I agree with you Deepak. Most startling about Bufet’s statement is that he calls derivatives as complex ala “weapons of financial destruction” and at the same time he has deals with the same instruments.

    I agree it is almost blasphemous to criticize Buffet but when he himself admits he does not understand the instruments he has invested in, I think he deserves criticism especially when the share has gone down by so much.