What Warren thinks... - Apr.

14, 2008

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APRIL 14, 2008: 10:23 AM EDT

What Warren thinks...
With Wall Street in chaos, Fortune naturally went to Omaha looking for wisdom. Warren Buffett talks about the economy, the credit crisis, Bear Stearns, and more.
By Nicholas Varchaver, (Fortune Magazine) -- If Berkshire Hathaway's annual meeting, scheduled for May 3 this year, is known as the Woodstock of Capitalism, then perhaps this is the equivalent of Bob Dylan playing a private show in his own house: Some 15 times a year Berkshire CEO Warren Buffett invites a group of business students for an intensive day of learning. The students tour one or two of the company's businesses and then proceed to Berkshire (BRKA, Fortune 500) headquarters in downtown Omaha, where Buffett opens the floor to two hours of questions and answers. Later everyone repairs to one of his favorite restaurants, where he treats them to lunch and root beer floats. Finally, each student gets the chance to pose for a photo with Buffett. In early April the megabillionaire hosted 150 students from the University of Pennsylvania's Wharton School (which Buffett attended) and offered Fortune the rare opportunity to sit in as he expounded on everything from the Bear Stearns (BSC, Fortune 500) bailout to the prognosis for the economy to whether he'd rather be CEO of GE (GE, Fortune 500) - or a paperboy. What follows are edited excerpts from his question-and-answer session with the students, his lunchtime chat with the Whartonites over chicken parmigiana at Piccolo Pete's, and an interview with Fortune in his office. Buffett began by welcoming the students with an array of Coca-Cola products. ("Berkshire owns a little over 8% of Coke, so we get the profit on one out of 12 cans. I don't care whether you drink it, but just open the cans, if you will.") He then plunged into weightier matters: Before we start in on questions, 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

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At Piccolo Pete's. incidentally. But they're not huge relative to the $20 trillion in total market value. financial markets are losing their competitive edge? And what's the right balance between confidence-inspiring standards and .com/pt/cpt?action=cpt&title=What. It's very. Buffett sat at a table with 12 Whartonites and bantered over many topics. It's incredible. It was set up to take care of hurricane insurance.if you gave me 100 of the smartest people you can imagine to work for me. they raise the premium taxes. We got one bid at an 11.. As a dramatic illustration. take two of the biggest accounting disasters in the past ten years: Freddie Mac and Fannie Mae. I don't think we're losing our edge. the same time. I mean. If I were appointed a new regulator . I think we've got fabulous capital markets in this country. all their derivative positions.87%. which is a creature of the state of Florida. you don't want a capital market that functions perfectly if you're in my business. [Note to Warren: They stand for Office of Federal Housing Enterprise Oversight. I wouldn't be able to tell you how they were doing.it gets very. there are costs to Sarbanes-Oxley. when fear takes over. between regulation and the Wild West? Well. I'm not sure what all the letters stand for. 2 of 5 6/8/2009 12:05 AM . these are two incredibly important institutions. And a big issue. where he has dined with everyone from Microsoft's Bill Gates to the New York Yankees' Alex Rodriguez. Nobody knew what would be unleashed when you had thousands of counterparties with. The counterparty behavior and risk was a big part of why the Treasury and the Fed felt that they had to move in over a weekend at Bear Stearns.. all their stock positions and currency positions. and they get screwed up often enough to make them even more fabulous. So the government set up an organization called OFHEO. some of which are wasted. And I think they were right to do it.printthis. contracts with a $14 trillion notional value. Here's one from yesterday. two for two! It's very. I mean. frequently the same credit will appear more than once. see box on page 74] of about $4 billion. the same dealer.. So wild things happen in the markets.] But if you go to OFHEO's website. they accounted for over 40% of the mortgage flow a few years back. I mean. eight or nine weeks.33% interest rate. Right now I think they're up to 70%. We bid on this particular issue . very. people react just as irrationally as they have in the past. and one went for 6.. and it's backed by premium taxes. And the markets have not gotten more rational over the years. and they always will. What that would have done to the markets.. for more.0%. OFHEO had 200 employees. They've become more followed. I read someplace. as they like to say in academic circles every time they find something that disagrees with their theory. There's nothing wrong with the credit. and if they have a big hurricane and the fund becomes inadequate. .. So regulating is an important part of the system.. 14. So we bid on three different Citizens securities that day. We're talking billions and billions of dollars of misstatements at both places. . One that we didn't buy went for 9. very complicated. People continue to do foolish things no matter what the regulation is. Their job was simply to look at two companies and say.What Warren thinks.this happens to be Citizens Insurance. 2008 http://cnnmoney. This is not some little anomaly. "Are these guys behaving like they're supposed to?" And of course what happened were two of the greatest accounting misstatements in history while these 200 people had their jobs. I mean. They're quasi-governmental in nature. you'll find that its purpose was to just watch over these two companies.clickability. The efficacy of it is really tough. Berkshire has built up a position in auction-rate securities [bonds whose interest rates are periodically reset at auction. And what we have seen there is really quite phenomenal. what that would have done to other counterparties in turn .S. There are significant limits to what regulation can accomplish. Those people would have tried to unwind all those contracts if there had been a bankruptcy. The fascinating thing is that on these bid lists.. But when people panic. or when greed takes over. It's the same bond. and every day I got the positions from the biggest institutions. Every day we get bid lists. Now. very hard to regulate people. Do you think the U. very hard to regulate when you get into very complex instruments where you've got hundreds of counterparties.Apr.

Apr. or delivering papers. They're all moderate in their approach. often in hammy poses (wrestling for his wallet was a favorite). So I am now a political bigamist. How do you get your ideas? I just read. I feel that if a Republican wins. And they should buy it over time.What Warren thinks. So leveraging up was one hell of a stimulus for the economy. and you don't buy all at one time. Any low-cost index fund. If that was one hell of a stimulus. And he's a great guy. I told Hillary that I would support her if she ran. each one took his or her turn with Buffett. How does the current turmoil stack up against past crises? Well.com/pt/cpt?action=cpt&title=What.] What advice would you give to someone who is not a professional investor? Where should they put their money? Well.. the one we don't know for sure about is Barack. But I feel either would be great. and a lot of that does not have a problem. a 77-year-old's version of A Hard Day's Night ensued. and Jeff Immelt is a friend of mine.. When Buffett said he was ready to pose for photographs. And that's just from prime mortgages. but that was $330 billion of stimulus. In 2006 you had $330 billion of cash taken out in mortgage refinancings in the United States. I mean. I read all day.. I think we've got three unusually good candidates this time.clickability. Well. Every one has so many variables in it. They're not going to be able to pick the right price and the right time. . On the other hand. in the [family] grocery store. But think of all the things he has to do whether he wants to do them or not. I don't have to do anything I don't want to do. that's hard to say. and I told Barack I would support him if he ran. you name it.then they should just stay with index funds. I would. You've got $20 trillion of residential real estate and you've got $11 trillion of mortgages. we talk about having $150 billion of stimulus now. 2008 http://cnnmoney. That's not from subprime mortgages. You just make sure you own a piece of American business. That's a hell of a lot . we put $500 million in PetroChina. all 150 students stampeded out of the room within seconds and formed a massive line. And actually. which was really tough. Was that your first job? Well. I worked for my grandfather. but a lot of it does. I know you had a paper route. All I did was read the annual report. For the next half hour. he has the chance to be the most transformational too. Then. he drove this Fortune writer back to his office and continued fielding questions.printthis. I would deliver papers. do you think the $150 billion government stimulus plan will 3 of 5 6/8/2009 12:05 AM .and very few should try to do that . if they're not going to be an active investor . I can think about what I want to think. It might be wonderful to be head of GE. as he started to leave. What they want to do is avoid the wrong price and wrong stock. I enjoyed doing that. John McCain would be the one I would prefer. Once free. But there's no question that this time there's extreme leveraging and in some cases the extreme prices of residential housing or buyouts. 14. How do you feel about the election? Way before they both filed. [Editor's note: Berkshire purchased the shares five years ago and sold them in 2007 for $4 billion. with a pack of 30 students trailing him to his gold Cadillac..I mean. But if you gave me the choice of being CEO of General Electric or IBM or General Motors.

And it's very hard to evaluate. you took a lower tranche of a mortgage-backed security and did 100 of those and thought you were diversifying risk. but the idea that this is uncorrelated risk and therefore you can take the CDO and call the top 50% of it super-senior ..printthis. . It's a bunch of juniors all put together. Hell. which was called private equity this time. and now you didn't have it all concentrated in your banks. so I don't think people should sell stocks because of that.it isn't super-senior or anything. You've got a mortgage industry that's deleveraging. you've got 50-times-300 pages to read. my guess is the Fed wouldn't have had to do what it did.000 pages to read to understand one security. nobody knows what the hell they're doing. You've got a banking system that's hung up with lots of that. Finance has gotten so complex. they had all these models. If Bear Stearns had not had a derivatives book. a lot of pain. But I say that in any large financial organization. it can't be done. I think so. make an impact? Well. He would say that you've spread risk throughout the world by all these instruments. it's $150 billion more than we'd have otherwise.and the terms got terrible and all that. And the juniors all correlate. and you know. Now. And the worst thing you can have is models and spreadsheets. it's 15. I think I know my limits in terms of how much I can sort of process. Now if you're going to understand that CDO. Do you find it striking that banks keep looking into their investments and not knowing what they have? I read a few prospectuses for residential-mortgage-backed securities . The scenario you're describing suggests we're a long way from turning a corner. I'm the chief risk officer at Berkshire. And then the simultaneous.. And the consequences kind of roll through in different ways.mortgages.. You create a CDO by taking one of the lower tranches of that one and 50 others like it.clickability. they're all subject to the same thing. and then those all tranched into maybe 30 slices. more or less.What Warren thinks. I also don't think they should buy stocks because of that. how will investors ever know when it's safe? They can't. deleveraging by its nature takes a lot of time. But it's not like we haven't had stimulus. Their investment strategy should factor in that (a) if you knew what was going to 4 of 5 6/8/2009 12:05 AM . LBO boom. they fell apart. 2008 http://cnnmoney. they can't. try to read the DNA of the people running the companies. and it's going to be painful. it seems everybody says it'll be short and shallow. What should we say to investors now? The answer is you don't want investors to think that what they read today is important in terms of their investment strategy. It's ridiculous. thousands of mortgages backing them. 14. If big financial institutions don't seem to know what's in their portfolios. They've got to. I mean. I mean. Your OFHEO example implies you're not too optimistic about regulation. with so much interdependency. I mean. But what you've done is you've interconnected the solvency of institutions to a degree that probably nobody anticipated. And of course. I don't invest a dime based on macro forecasts. at Salomon.. If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared. but it looks like it's just the opposite. I argued with Alan Greenspan some about this at [Washington Post chairman] Don Graham's dinner. you're now up to 750.Apr. You know.000. it may be a little different whether they're in California or Nebraska.com/pt/cpt?action=cpt&title=What. The abuses keep coming back . the CEO has to be the chief risk officer. in effect. When you start buying tranches of other instruments. I mean.

you shouldn't get greedy when others get greedy and fearful when others get fearful. now seems like a good time to be greedy. � 2007 Cable News Network LP. for the long term? The American economy is going to do fine. But you're still bullish about the U. But it stands to reason. Stocks are a good thing to own over time. Of course.com/2008/04/11/news/newsmakers/varchaver_buffett. happen in the economy. certainly trying to pick the little beauties here and there isn't going to work either. you still wouldn't necessarily know what was going to happen in the stock market. There's only two things you can do wrong: You can buy the wrong ones. You know..fortune/index.cnn.clickability. I mean. People are pretty fearful. Or three years ago. 14. By your rule. you know.. And the only way an investor can get killed is by high fees or by trying to outsmart the market. Find this article at: http://money.htm SAVE THIS | EMAIL THIS | Close Check the box to include the list of links referenced in the article. I mean. . long term. and you can buy or sell them at the wrong time.S. LLP.printthis.What Warren thinks. and if a cross section of American industry doesn't work. basically. But they could buy a cross section of American industry. They are going in that direction. It's a positive-sum game. Then they just have to worry about getting greedy. try to stay away from that. if you don't believe that. I always say you should get greedy when others are fearful and fearful when others are greedy. forget about buying stocks anyway. we get more productive every year. Stocks are a better buy today than they were a year ago. But that's too much to expect. You're right.. 5 of 5 6/8/2009 12:05 AM .Apr. 2008 http://cnnmoney. And the truth is you never need to sell them. But it won't do fine every year and every week and every month.. And (b) they can't pick stocks that are better than average. That's why stocks are cheaper. At a minimum.com/pt/cpt?action=cpt&title=What.

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