Saturday, February 28, 2009 2 comments ++[ CLICK TO COMMENT ]++

Wisdom from the Oracle of Omaha... Thoughts on Buffett's 2008 Shareholder Letter

I don't usually cover Warren Buffett's shareholder letters since it is covered in detail by almost everyone else. You are probably also better off reading some thoughts from some value investor or Berkshire investor than someone like me who doesn't really follow him closely. Nevertheless, the latest letter, the 2008 Berkshire Hathaway Shareholder Letter, is worth reading in order to get a feel for the thinking of Buffett in the middle of a major stock market crash. I also thought it was worth covering it on my blog given how he devotes a section to the monoline bond insurers.

As is generally the case on this blog, rather than summarizing his letter, let me present my opinion on some things I find interesting...

Worst Year Ever

Warren Buffett evaluates his performance of Berkshire Hathaway by looking at book value. I think this is the proper metric in the long run, especially since its holdings are not public, but short-term investors are probably correct in looking at share price performance. Ever since he took complete management control Berkshire Hathaway in 1965, this has been his worst year. Book value declined 9.5% in 2008. The S&P 500 total return was -37% last year versus a -32%.

Berkshire is a diversified conglomerate that is primarily an insurance company. It is far more diversified than a typical company, and since two of its core holdings are insurance and utilities, it is not highly correlated with the economy.

Quite a number of investors invest in Berkshire Hathaway, not for its holdings, but for the investing skills of Warren Buffett. On that front, it seems Buffett made some mistakes last year but I believe that he has set up some investments with huge potential in the future (all those covertibles for instance.)


Utilities are a huge chunk of Berkshire these days. I personally don't think they are attractive for small investors given their low returns (almost always capped by government) and lack of mispricing (generally efficiently priced by the market.) What is attractive about them, though, is that they are not correlated strongly with the economy. As long as the utility isn't overly indebted, it will see a continuous cash flow whether the economy booms or not. I found it interesting that Berkshire hasn't really extracted any wealth from their utilities in the last decade or so:

In our utility business, we spend all we earn, and then some, in order to fulfill the needs of our service areas. Indeed, MidAmerican has not paid a dividend since Berkshire bought into the company in early 2000. Its earnings have instead been reinvested to develop the utility systems our customers require and deserve. In exchange, we have been allowed to earn a fair return on the huge sums we have invested. It’s a great partnership for all concerned.

It seems Berkshire hasn't received a dividend from its utility holidng and instead reinvests all the earnings. This builds the business and likely increases its moat (utilities tend to be monopolies or oligopolies so their moat likely doesn't matter as much as if they were in a highly competitive industry.) I suspect that an arrangement like this cannot be pursued by many others. It requires very-long-term thinking and the ability of someone to invest billions without getting paid for a decade. It's like owning a non-marketable zero-coupon bond whose benefit you can't realize for a decade or more. How many can do that? Private equity or hedge funds would want to be paid back quickly and retail investors also would be impatient waiting a decade to be paid.

As Buffett remarks later on, this ability of Berkshire to behave this way shines a favourable light in the eyes of regulators:

In the regulated utility field there are no large family-owned businesses. Here, Berkshire hopes to be the “buyer of choice” of regulators. It is they, rather than selling shareholders, who judge the fitness of purchasers when transactions are proposed.

There is no hiding your history when you stand before these regulators. They can – and do – call their counterparts in other states where you operate and ask how you have behaved in respect to all aspects of the business, including a willingness to commit adequate equity capital.

Given how Berkshire Hathaway is very large and can only make big investments, utilities provide opportunities for it. Berkshire Hathaway is primarily an insurance company but it would be not surprise me if it ended up being mostly a utility in 20 years. Once Warren Buffett leaves, I suspect insurance operations, which are very complex and only a few understand, will lose their favour.

Subprime Mortages Aren't the Problem

Buffett clearly shows how subprime is not the problem with the mortgage crisis. Rather, it is the lending standards and the thinking of the borrower.

Instead, in an eerie rerun of that disaster, the same mistakes were repeated with conventional homes in the 2004-07 period: Lenders happily made loans that borrowers couldn’t repay out of their incomes, and borrowers just as happily signed up to meet those payments. Both parties counted on “house-price appreciation” to make this otherwise impossible arrangement work. It was Scarlett O’Hara all over again: “I’ll think about it tomorrow.” The consequences of this behavior are now reverberating through every corner of our economy.

Clayton’s 198,888 borrowers, however, have continued to pay normally throughout the housing crash, handing us no unexpected losses. This is not because these borrowers are unusually creditworthy, a point proved by FICO scores (a standard measure of credit risk). Their median FICO score is 644, compared to a national median of 723, and about 35% are below 620, the segment usually designated “sub-prime.” Many disastrous pools of mortgages on conventional homes are populated by borrowers with far better credit, as measured by FICO scores.

Yet at yearend, our delinquency rate on loans we have originated was 3.6%, up only modestly from 2.9% in 2006 and 2.9% in 2004. (In addition to our originated loans, we’ve also bought bulk portfolios of various types from other financial institutions.) Clayton’s foreclosures during 2008 were 3.0% of originated loans compared to 3.8% in 2006 and 5.3% in 2004.

Why are our borrowers – characteristically people with modest incomes and far-from-great credit scores – performing so well? The answer is elementary, going right back to Lending 101. Our borrowers simply looked at how full-bore mortgage payments would compare with their actual – not hoped-for – income and then decided whether they could live with that commitment. Simply put, they took out a mortgage with the intention of paying it off, whatever the course of home prices.

I think this is an important point to discuss given how it seems that a theory is gaining popularity on the right that this was all due to subprime borrowers and the government, through Fannie Mae and Freddie Mac, were the cause. The fact of the matter is that, here we have a case where many of Berkshire Hathaway's subprime borrowers are actually paying off their mortgages. In contrast, we have a whole hoard of higher quality borrowers (some subprime but also Alt-A and prime) who are defaulting en masse.

The following is another point that is missed by many:

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.

There are many bearish estimates that project losses simply based on upside-down home mortgages. Although some people will walk away in those cases, others won't. The ones that will likely default upon an upside-down mortage value are the speculators/investors and those that clearly cannot afford to pay--even if rates are low these two sets will walk away. The government, in my opinion, should try to help the at-risk borrowers who don't fall into these two categories from defaulting. It's easier said than done and I'm not knowledgeable enough about mortgages to know how you go about doing that. The easiest "solution" would be to strengthen the economy but I'm a free-market-type who doesn't believe the government controls the economy (they just influence it.)

Oh, one other thing... I keep saying this but it seems many still think that we are dealing with a subprime residential mortgage problem. I wish if it were only so. Instead, what we are facing is a credit bust. Although the subprime residential mortgages are a big part of the problem, we also have looming problems in commercial real estate, corporate debt, and even government debt (particularly in emerging markets.)

Adverse Impact of Government Intervention

It's commonly known that government intervention can result in adverse outcomes. That's why most of us who are free-market-oriented (although not to the same degree) like to keep government intervention limited. Buffett provides an example of how the recent government intervention threatens companies in good standing such as his firm:

Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

This is an issue that I raised many months ago when the CEO of BT&T bank blasted the government actions. Needless to say, small banks like BT&T were disadvantaged while the megabanks were getting literally free money.

To be fair, it should be noted that Berkshire also benefits from government funding of some of its holdings. For instance, I have a feeling that Goldman Sachs and G.E. may have been very close to bankruptcy if it weren't for the cheap funding from the government. G.E. in particular saw the secrutization market lock up and it may have seen catastrophic losses without cheap funding from the government. So, although Clayton is hurt by the cheap financing of competitors, G.E. and Goldman Sachs would have been far worse off.

Having said that, I think Buffett's example can be used to illustrate the negative side-effects of government actions. This is one of the main reasons I am in favour of nationalization of failing firms, followed by the break up of such firms. Ideally, the failing firms themselves should break up on their own but the executives, directors, and shareholders seem unwilling to do that. All these failing companies need to be broken up and sold off. AIG, for example, has no business staying together as a massive conglomerate. Similarly, Citigroup's business model is dead and it'll be impossible to keep it together. I would even go as far as to say that Ambac, once the largest holding for me, should be allowed to fail if it can't survive on its own. It'll be painful for me and other shareholders but Ambac has no business underwriting bond insurance if it doesn't know what it's doing.

So far, I'm encouraged to see that Royal Bank of Scotland seems to have been taken over by the government. I also like how RBS seems to be retrenching back to Britain by selling off its foreign assets. I don't know if this is just for show but if it is genuine and is indicative of the start of a break-up, it will be welcome. Countries like Britain, Switzerland, Ireland, and others, may have some difficulty breaking up the banks since there are only a few banks in those countries. It should be far easier in USA where there are thousands of banks, many of them well-run and untouched by the subprime mortgage mess, that can buy off some of the assets.

Bond Insurance

Buffett has a section devoted entirely to monoline bond insurance (if you are interested start at page 13). Buffett actually says that the offer he made to the tainted monolines for the muni bond business, which was rejected, was way too high.

We would have charged a 11⁄2% rate to take over the guarantees on about $822 billion of bonds. If our offer had been accepted, we would have been required to pay any losses suffered by investors who owned these bonds – a guarantee stretching for 40 years in some cases. Ours was not a frivolous proposal: For reasons we will come to later, it involved substantial risk for Berkshire.

The monolines summarily rejected our offer, in some cases appending an insult or two. In the end, though, the turndowns proved to be very good news for us, because it became apparent that I had severely underpriced our offer.

Thereafter, we wrote about $15.6 billion of insurance in the secondary market. And here’s the punch line: About 77% of this business was on bonds that were already insured, largely by the three aforementioned monolines. In these agreements, we have to pay for defaults only if the original insurer is financially unable to do so.

We wrote this “second-to-pay” insurance for rates averaging 3.3%. That’s right; we have been paid far more for becoming the second to pay than the 1.5% we would have earlier charged to be the first to pay. In one extreme case, we actually agreed to be fourth to pay, nonetheless receiving about three times the 1% premium charged by the monoline that remains first to pay. In other words, three other monolines have to first go broke before we need to write a check.

I think Buffett's comment is misleading. He says that the offer made initially was too high. But that is only because the distress later on allowed Berkshire to write insurance at far better terms for already insured bonds. I doubt that if Berkshire Hathaway Assurance were to ramp up to the level of the portfolio he was offering to buy, he would have been able to charge high rates.

In terms of new business, it looks like BHAC has solidy taken the lead in the bond insurance business, with Buffett remarking: "In addition to our book of secondary business, we have also written $3.7 billion of primary business for a premium of $96 million." Roughly speaking that's a premium of 2.6% which seems to be a leverage of around 39. The market is in stress, with some even claiming that bond insurance is useless, so I'm not sure what the future holds. The $3.7 billion is very small by historical standards. It remains to be seen if BHAC will remain in the market. Although the probability of companies like MBIA or Ambac recovering seems remote, Jay Brown, CEO of MBIA, has remarked how Berkshire is a bit player and will leave the market when it becomes unattractive.

Muni Bond Insurance Very Risky

Buffett also presents a view that I hadn't seen being discussed elsewhere. Namely, muni bond insurance can end up being far riskier than it seems. There are a lot of people who talk about the potential for increasing municipality defaults and financial crises and that's not new. What is new, however, is the possibility of municipalities/states/etc seeking concessions from the bond insurers.

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.

Buffett makes some great points about muni bond insurance. One problem he mentions is that many municipalities are going to have serious issues with pension obligations (as a aidenote, this is also problem for some corporations.) Unfortunately, baby boomers have been promising themselves way beyond what anyone can afford. This is something that will end, similar to how the pension plans of American automakers are going to be cut eventually.

The core problem that Buffett cites with muni bond insurance is a social issue tha I had never considered--and I suspect very few running any of these insurers have either. Bond insurers have faced serious problems in the past including the New York City debt problems, Eurotunnel default, and hurricanes Katrina and Wilma. But I don't think anyone has considered what Buffet is talking about. Namely, what if the municipalities/states/public-private partnerships/quasi-govt entities/etc simply refuse to balance their books without big concessions from the insurers? This is a serious threat to any insurer. I wonder what will happen. It's also not clear what the legal rights of insurers are in those cases. Something for management of bond insurers to think about...

Investment Mistakes & Successes

Although Buffett sold off a huge chunk of Johnson & Johnson (JNJ) and some Buffett fans were wondering if JNJ was a mistake, that seeems to have been to raise money to fund the Goldman Sachs, G.E., and Wrigley deals. Instead, the big mistake seems to have been ConocoPhillips (COP):

Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.

ConocoPhillips isn't going bankrupt but it does look like a mistake. Commodities are very volatile so who knows what will actually happen in the end but so far, the picture looks bleak. On top of declining commodity prices which will lower their profits, many commodity businesses, whether it is oil&gas companies or copper miners or natural gas producers or steel companies, are producing huge non-cash losses from writing off big chunks of their book value. Although it's a non-cash loss, these are still indicative of wealth destruction. Generally these write-offs are due to buying assets (land, mines, competitors, etc) at inflated prices in the last few years. Barring a strong recovery in the world economy, all these assets will end up being near-worthless and uneconomic. Commodity investors that rely on book values should pay careful attention and discount all the goodwill and other overvalued asset purchases in the last few years.

Buffett does say that he thinks oil will be higher in the future but I don't share that view. I can actually see it bouncing up and down but I don't think it will rise significantly enough to make a macro bet on it.

I made some other already-recognizable errors as well. They were smaller, but unfortunately not that small. During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”

LOL Reminds me of my Ambac investment, except it was a large holding of mine whereas Buffett's picks are very small for him. I'm surprised that Buffett got totally blown up with this. I remember looking at some Irish banks last year (I think I even mentioned it as worth investigating) but the macro situation was very flaky over there.

On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus.

I like these deals. I think he is setting himseful up for a win a few years down the road. Very reminiscent of his Gillette purchase in the early 90's. The macro outlook for financials is poor but I like the structure. He basically gets convertibles that allow him to profit fully on the upside, while the downside is somewhat limited. Even if we get stuck in a multi-year bear market, he'll do well (as long as the companies don't go bankrupt, which I don't think they will.)

The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

I think it's way too early to call it a government bond bubble but government bonds are certainly unattractive from a long term point of view.

Derivatives Are Dangerous

I'm not into derivatives but anyone interested should read his letter, where he devotes many pages to it (including Berkshire's derivatives bets.) What is interesting to me is his suggestion that the Black-Scholes formula, which is widely used to value options, misprices long-term options.

The Black-Scholes formula has approached the status of holy writ in finance, and we use it when valuing our equity put options for financial statement purposes. Key inputs to the calculation include a contract’s maturity and strike price, as well as the analyst’s expectations for volatility, interest rates and dividends.

If the formula is applied to extended time periods, however, it can produce absurd results. In fairness, Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first unveiled the formula.


The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probabilityweighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm a century from now.)

Though historical volatility is a useful – but far from foolproof – concept in valuing short-term options, its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the Black-Scholes formula now place on our long-term put options overstate our liability, hough the overstatement will diminish as the contracts approach maturity.

I wonder if this means that writing put options will end up being profitable in the long-run. I wonder if the same applies to writing call options. Anyway, I'm not into derivatives and likely won't ever use them (unless I work in this field or something.)

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2 Response to Wisdom from the Oracle of Omaha... Thoughts on Buffett's 2008 Shareholder Letter

March 2, 2009 at 3:57 AM

it is intriguing how this move onto utilities is similar to the strategy behing the Australian Mcquairie Bank (incidentally a buyer for Puget in Seattle).
the valuation of long-term puts has received some attention in academia, cf. the abstract from a paper by Bondarenko (2003):

As an aside, this idea ---if true--- sort of goes agains the heart of Nassim Taleb's trading strategy, buying far-out-of-the-money puts and calls. Or better said, he would be right only if there was a catastrophic loss in the stockmarket. Of course, in those circumstances getting yourself paid back might be hard.

March 2, 2009 at 11:55 AM

"it is intriguing how this move onto utilities is similar to the strategy behing the Australian Mcquairie Bank (incidentally a buyer for Puget in Seattle)."
Yep... there is a difference though. All those buyout funds likely leverage up the utility and are in it for the quick buck. Although some of the buyers, at least in the Puget Sound casse, are government funds that should be in it for the long run. Buffett, in contrast, is in it for the long run and likely doesn't use much leverage. I think Buffett is going for market share gains rather than profits. But none of this is attractive to small investors. Safety? yes. But high returns? nope :(
I am not a fan of Nassim Taleb. I am not that familiar with his ideas but his strategy of buying way-out-of-the-money options is likely a loser in the long run. Unless you face a massive stock market crash of course. Taleb's strategy would look good right now (given the crash) but I'll bet he won't make any money for the next 25 years.
I think Buffett's put options will be profitable, even with the current stock market crash. I understand his logic. As long as the economy grows, even if slowly, there is a high chance of turning a profit on it.
However, I wonder about his CDS contracts. If I understood him correctly, he insured some high-quality corporations against default. A lot of so-called high quality companies have collapsed and the underwriting skills need to be nop notch to avoid massive losses. For instance, how many would have thought Bank of America is on the verge of collapse (I have no idea but I suspect nationalization is equivalent to default)? Or how about companies like Chesapeake or Dow Chemical?

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