Warren Buffett Fortune Interview

Thanks to magalengo's forum post at gurufocus.com for the original mention of the following Fortune article on Warren Buffet. It's a quick read and it provides Buffett's thinking on the current crisis. Here are some excerpts of what I find interesting:

(source: What Warren thinks..., By Nicholas Varchaver, April 11, 2008. Fortune)

...I would like to tell you about one thing going on recently. It may have some meaning to you if you're still being taught efficient-market theory, which was standard procedure 25 years ago. But we've had a recent illustration of why the theory is misguided. In the past seven or eight or nine weeks, Berkshire has built up a position in auction-rate securities [bonds whose interest rates are periodically reset at auction; for more, see box on page 74] of about $4 billion...

Here's one from yesterday. We bid on this particular issue - this happens to be Citizens Insurance, which is a creature of the state of Florida. It was set up to take care of hurricane insurance, and it's backed by premium taxes, and if they have a big hurricane and the fund becomes inadequate, they raise the premium taxes. There's nothing wrong with the credit. So we bid on three different Citizens securities that day. We got one bid at an 11.33% interest rate. One that we didn't buy went for 9.87%, and one went for 6.0%. It's the same bond, the same time, the same dealer. And a big issue. This is not some little anomaly, as they like to say in academic circles every time they find something that disagrees with their theory.

So wild things happen in the markets. And the markets have not gotten more rational over the years. They've become more followed. But when people panic, when fear takes over, or when greed takes over, people react just as irrationally as they have in the past.

The ARS market problems were caused partly due to the collapse of confidence in the monoline bond insurers. In any case, it is totally irrational for so-called "municipal" bonds to trade at such high yields. From what I understand, the resets are generally for a short period of time but it just goes to show how fear can drive the market.

The collapse in the yields of T-bills (i.e. investors fleeing to safe bills at ridiculously low rates) at certain points in the last few months is another highly irrational behaviour.

Question: What advice would you give to someone who is not a professional investor? Where should they put their money?

Warren Buffett Well, if they're not going to be an active investor - and very few should try to do that - then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They're not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don't buy all at one time.

Buffett, like Benjamin Graham, has repeated the view that the vast majority of people should be passive investors (preferably in low-cost index funds). I personally am seeing if I'm cut out for this stuff, and if I don't feel I can do well within the next 5 years, I'm going to go passive.

Interviewer: The scenario you're describing [regarding the credit crisis] suggests we're a long way from turning a corner.

Warren Buffett: I think so. I mean, it seems everybody says it'll be short and shallow, but it looks like it's just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don't invest a dime based on macro forecasts, so I don't think people should sell stocks because of that. I also don't think they should buy stocks because of that.

Buffett is quite pessimistic on the current crisis. Buffett usually doesn't make good macro calls but it is still worth paying attention to him. The big scary thing about the current crisis is that America is going through a massive credit bubble. Typically credit bubbles result in massive dislocations. The optimistic case rests on the fact that corporate balance sheets are strong and stock market valuations aren't bubblicious.

As Buffett alluded to, it's not worth trying to invest off these scenarios of what may or may not happen. The situation should be considered but if something is undervalued and is strong, it should do well.

I read a few prospectuses for residential-mortgage-backed securities - mortgages, thousands of mortgages backing them, and then those all tranched into maybe 30 slices. You create a CDO by taking one of the lower tranches of that one and 50 others like it. Now if you're going to understand that CDO, you've got 50-times-300 pages to read, it's 15,000. If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared, you're now up to 750,000 pages to read to understand one security. I mean, it can't be done. When you start buying tranches of other instruments, nobody knows what the hell they're doing. It's ridiculous. And of course, you took a lower tranche of a mortgage-backed security and did 100 of those and thought you were diversifying risk. Hell, they're all subject to the same thing. I mean, it may be a little different whether they're in California or Nebraska, but the idea that this is uncorrelated risk and therefore you can take the CDO and call the top 50% of it super-senior - it isn't super-senior or anything. It's a bunch of juniors all put together. And the juniors all correlate.

The peanut gallery often put forth theories stating that banks, bond insuers and bond rating agencies were maliciously deceiving people with these structured products. I don't work in the field but I believe most of the problems are due to the complexity--or stupidity, if you are one that equates too much complexity with stupidity. Buffett points out how you may have to read 750,000 pages to understand a CDO-squared thoroughly. Since we can be certain no one ever read through the documents for one CDO-squared, let alone two or three or twenty, a lot of these instruments were likely analyzed using computer models. Instead of reading through 750,000 pages for each CDO-squared, so-called finance professionals likely relied on some automated system.

If the computer modeling falls apart--as it ended up happening--no one knows what a CDO-squared is worth. You can see why no one, including the experts at the monolines, can credibly argue against skeptics like William Ackman: no one has any clue what a CDO-squared's behaviour will be or what its likely loss will be. I suspect the complexity of CDOs--not its potential losses but its complexity--may be one big reason Martin Whitman, Warburg Pincus, and others, picked MBIA over Ambac.

The only two things that will save the monolines are (i) losses don't have to be paid out for a long period of time for many insured products, and (ii) favourable legal structure allows payments to flow to the senior tranches.

(For what it's worth, I don't think William Ackman even knows what the losses on the CDOs and CDO-squareds will be. Remember that he shorted (via CDS) the monolines 4 years ago, not because of the subprime mortgages but because of muni bonds. He felt that the muni bond insurance made no sense. He was actually wrong! Very few doubt the viability of muni bond insurance (this argument died soon after Buffett entered the market basically indicated that there is a viable industry here.) What caused the collapse of the monolines was subprime insurance written in late 2005 or afterwards. Ackman shorted long before the problematic insurance was written. I'll give credit to Ackman for his call on the monolines. I'm not taking anything away from that. My point here is that I doubt that even he can peg a price on these CDOs or CDO-squareds. In other words, I don't think anyone knows for sure one way or the other what these CDOs and CDO-squareds are worth.)