Friday, October 3, 2008 0 comments ++[ CLICK TO COMMENT ]++

Is Buffett Wrong?

Warren Buffett suggested Thursday that the U.S. Treasury team with private investors to buy the distressed mortgage assets at the center of the controversial $700 billion Wall Street bailout, and said the price tag of the rescue plan may have to rise.

A Fortune article recaps Buffett's view that the cost is going to have to be much higher. I never thought it would be possible but Buffett is essentially superbearish on the markets and the economy. I personally think he is wrong. The situation, although very bad, doesn't seem as apocalyptic as he implies.

"It will cost more to solve this problem today than it did two weeks ago," said Buffett, referring to when Treasury Secretary Henry Paulson's first proposed that Congress help rescue Wall Street after Lehman Brothers went bankrupt, Merrill Lynch was sold to Bank of America, and American International Group had to be rescued.

"If we don't get it solved next week," added Buffett, "I may go back to delivering papers."

Although I'm not experienced and clearly don't have the historical sense of Buffett, what he says sounds ridiculous. How can he say that the cost has gone up within 2 weeks? If that was the case, then wouldn't the cost have been really low 6 months ago? I would argue that the cost 6 months ago was very similar to now.

The problem is that some of the events are inevitable! We all knew that real estate peaked in 2005 and the house prices were high. You didn't have to be bearish on housing to feel that prices were high (a good measure is price relative to rent; another is price relative to income.) By 2007 it was obvious that there was quite a bit of fraud, along with a huge number of people who bought houses they clearly couldn't afford. All this essentially means that parties involved in housing--homebuilders, building material suppliers, mortgage lenders, real estate investment funds, and so on--would get hit no matter what.

The fact that real-estate-oriented investment banks--Bear Stearns and Lehman Brothers were big players in real estate--ran into problems was almost a given. In particular, de-leveraging is a given and cannot be avoided.

The difficulty is separating the inevitable events from the undesirable ones that we can control. What the government should do is to mitigate any damage to non-real-estate businesses from the de-leveraging process. De-leveraging will impact everyone (especially if consumers de-leverage, which seems certain) but this should be about risk mitigation rather than trying to avoid the unwinding.

Buffett suggests an alternate bailout plan:

But he described a plan he thought of Thursday morning on the way to the Summit that would allow Treasury and private investors to buy assets together. He said his proposal would kickstart demand for mortgage-backed securities, help find a market price for these troubled assets and make it more likely that taxpayers would be made whole or even come out ahead in the bailout.

Under Buffett's plan, Treasury would lend hedge funds, Wall Street firms or any other investors 80% of the price for distressed assets. Investors would benefit from borrowing at lower rates available to the Treasury. But the government would get first claim on the sale of those assets, which means it would get its loan back plus interest and possibly turn a profit. Only then would investors see a penny.

"Now you have someone with 20% skin in the game," explained Buffett. "Believe me, I won't be overpaying if I'm buying with that kind of leverage. And you have someone [the investors] to manage the assets to the extent they need to be managed."

This seems like trying to use the same strategy that got us into trouble in the first place. Namely, leverage and low cost of financing. The proposal here would definitely move the assets off the banks' balance sheets but the risk will lie with the government. A small portion of the risk (20%) will lie with investors but I think speculators will be tripping over themselves to participate if offered near-Treasury cost of financing with 5x leverage to buy assets.

One of the key assumptions with this plan is the view that asset prices will be higher than fire-sale prices due to the cheap financing. If this is the case, it will provide additional capital (more than the depressed mark-to-market values on their books) to the banks.


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