In 2010, the US government interviewed Warren Buffett as part of its investigation on the causes of the 2007-09 financial crisis.
The 103-page transcript of Buffett’s interview was released by the US government in March 2016, along with many other documents created during the investigation. The documents are a wonderful resource if you’re interested in gaining a deeper understanding of the worst economic meltdown seen in generations.
The transcript of Buffett’s interview is a fascinating treasure-trove of valuable insights from one of the best investors in the world today. Here are my favourite Buffett quotes from the transcript:
Spotting a great investment:
“And basically, the single-most important decision in evaluating a business is pricing power.
If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference.”
Causes of a bubble:
“[T]he only way you get a bubble is when basically a very high percentage of the population buys into some originally sound premise and – it’s quite interesting how that develops – originally sound premise that becomes distorted as time passes and people forget the original sound premise and start focusing solely on the price action.”
More on the causes of a bubble (emphasis mine):
“[W]hat my former boss, Ben Graham, made an observation, 50 or so years ago to me that it really stuck in my mind and now I’ve seen evidence of it. He said, “You can get in a whole lot more trouble in investing with a sound premise than with a false premise.”
If you have some premise that the moon is made of green cheese or something, it’s ridiculous on its face. If you come out with a premise that common stocks have done better than bonds — and I wrote about this in Fortune article in 2001 – because there was a famous little book in 2001 by Edgar Lawrence Smith – in 1924 by Edgar Lawrence Smith that made a study of common stocks versus bonds.
And it showed – he started out with the idea that bonds would over-perform during deflation and common stocks would over-perform during inflation. He went back and studied a whole bunch of periods and, lo and behold, his original hypothesis was wrong. He found that common stock always over-performed. And he started thinking about that and why was that.
Well, it was because there was a retained earnings factor. They sold – the dividend yield on stocks was the same as the yield on bonds, and on top of it, you had retained earnings. So they over-performed. That became the underlying bulwark for the ‘29 bubble. People thought stocks were starting to be wonderful and they forgot the limitations of the original premise, which was that if stocks were yielding the same as bonds, that they had this going…
…So after a while, the original premise, which becomes sort of the impetus for what later turns out to be a bubble is forgotten and the price action takes over.”
Even more on the causes of a bubble:
“It’s a totally sound premise that houses will become worth more over time because the dollar becomes worth less. It isn’t because – you know, construction costs go up. So it isn’t because houses are so wonderful, it’s because the dollar becomes worth less, and that a house that was bought 40 years ago is worth more today than it was then.
And since 66 or 67 percent of the people want to own their own home and because you can borrow money on it and you’re dreaming of buying a home, if you really believe that houses are going to go up in value, you buy one as soon as you can. And that’s a very sound premise. It’s related, of course, though, to houses selling at something like replacement price and not far outstripping inflation.
So this sound premise that it’s a good idea to buy a house this year because it’s probably going to cost more next year and you’re going to want a home, and the fact that you can finance it gets distorted over time if housing prices are going up 10 percent a year and inflation is a couple percent a year.
Soon the price action – or at some point the price action takes over, and you want to buy three houses and five houses and you want to buy it with nothing down and you want to agree to payments that you can’t make and all of that sort of thing, because it doesn’t make any difference: It’s going to be worth more next year.
And lender feels the same way. It really doesn’t make a difference if it’s a liar’s loan or you know what I mean? …because even if they have to take it over, it’s going to be worth more next year. And once that gathers momentum and it gets reinforced by price action and the original premise is forgotten, which it was in 1929.”
Detecting danger in financial institutions:
“Well, I didn’t know that they weren’t going to be good investments, but I was concerned about the management at both Freddie Mac and Fannie Mae, although our holdings were concentrated in Fannie Mac.
They were trying to – and proclaiming that they could increase earnings per share in some low double-digit range or something of the sort. And any time a large financial institution starts promising regular earnings increases, you’re going to have trouble, you know?
I mean, it isn’t given to man to be able to run a financial institution where different interest-rate scenarios will prevail on all of that so as to produce kind of smooth, regular earnings from a very large base to start with; and so if people are thinking that way, they are going to do things, maybe in accounting – as it turns out to be the case in both Freddie and Fannie – but also in operations that I would regard as unsound.”
There’s never just one problem:
“And, you know, there is seldom just one cockroach in the kitchen. You know, you turn on the light and, all of sudden, they all start scurrying around. And I wasn’t – I couldn’t find the light switch, but I had seen one.“
Having faith in the system:
“I was, in my own mind, I – there was only way both the financial world and the economy was going to come out of this situation of paralysis in September of 2008, and that was – I made the fundamental decision that we had really the right people in Bernanke and Paulson in there, where the President would back them up. That we had a government that would take the action and only the government could take the action to get an economic machine that had become stalled, basically, back into action.
And I didn’t know what they would do. I didn’t know what Congress would go – it really didn’t make much difference. The important thing was that the American public would come to believe that our government would do whatever it took. And I felt it would – it would have been suicide not to, but it hadn’t been done in the early ‘30s.
And therefore, I felt companies like General Electric or Goldman Sachs were going to be fine over time. But it was a bet essentially on the fact that the government would not really shirk its responsibility at the time like that, to leverage up when the rest of the world was trying to de-leverage and panicked.”
Understanding moral hazard:
Question to Buffett: “Would the American economy have been better off in the long run if there had been no exceptional government assistance to financial institutions? In other words, do you think we’ve increased the likelihood of moral hazard in the long run?”
Buffett’s response: “No, I think the moral hazard has been misunderstood in a big way. There is no moral hazard existing with shareholders of Citigroup, with Freddie Mac, with Fannie Mae, with WaMu, with Wachovia – you just go up and down the line. I mean, those people lost anywhere from 90 percent to 100 percent of their money, and the idea that they will walk away and think, “Ah, I’ve been saved by the federal government.”
I think just the companies that I’ve named there’s at least a half a trillion dollars of loss to common shareholders. Now, there’s another question with management, which we might get into later, but in terms of moral hazard, I don’t even understand why people talk about that in terms of equity holders.”
The difference between investing and speculating:
“It’s a tricky definition. You know, it’s like pornography, and that famous quote on that.
But I look at it in terms of the intent of the person engaging in the transaction, and an investment operation – though, it’s not the way Graham defines it in his book, but investment operation in my view is one where you look to the asset itself to determine your decision to lay out some money now to get some more money back later on.
So you look to the apartment house, you look to the stock, you look to the farm, in terms of what that will produce. And you don’t really care whether there is a quote on it at all. You are basically committing some funds now to get more funds later on, through the operation of the asset.
Speculation, I would define as much more focused on the price action of the stock, particularly that you, or the index future, or something of the sort. Because you are not really you are counting on for whatever factors, because you think quarterly earnings are going to be up or it’s going to split, or whatever it may be, or increase the dividend but you are not looking to the asset itself.”
The dangers of using borrowed money:
“Anything that increased leverage significantly tends to make – it can’t even create a crisis, but it would tend to accentuate any crisis that occurs.
I think you that if Lehman had been less leveraged, there would have been less problem in the way of problems. And part of that leverage arose from the use of derivatives, and part of the – part of the dislocation that took place afterwards arose from that.
And there’s some interesting material, if you look at – if you look at – I don’t know exactly what Lehman material I was looking at – but they had a netting arrangement with the Bank of America, as I remember.
And, you know, the day before they went broke – and just are very, very, very rough figures, from memory – but as I remember, the day before they went broke, Bank of America was in a minus position of $600 million, or something like that, they had deposited with, I think, JPMorgan in relation to Lehman. And I think the day they went broke, it reversed to a billion and a half in the other direction. And those are big numbers. And I think the numbers – I think I’m right on just order of magnitude.
So when things like that exist in the system, you know, it’s under stress for other reasons, it becomes a magnifying factor how big of a one, you don’t know. But Lehman – Lehman would have had less impact on the system if they had not had the derivative book that they had. Now, they probably had bad real estate investments and a whole bunch of other things as well.”
More on the dangers of using borrowed money:
“But it gets down to leverage overall. I mean, if you don’t have leverage, you don’t get in trouble. That’s the only way a smart person can go broke, basically. And I’ve always said, “If you’re smart, you don’t need it; and if you’re dumb, you shouldn’t be using it.””
The risks of financial derivatives:
“I think it’s a terribly difficult problem because – well, it was so difficult a problem, I didn’t think I could solve it.
We bought Gen Re, which had 23,000 derivative contracts. I could have hired 15 of the smartest people – math majors, Ph.D.s, and I could have given them carte blanche to devise any reporting system to me, that would enable me to get my mind around what exposures I had, and it wouldn’t have worked. The only answer was to get out of it.
Can you imagine, 23,000 contracts with 900 institutions all over the world, probably 200 of them with names I can’t pronounce, you know? And all of these contracts extending years in the future, multiple variables. You know, all of these – you can’t – you can’t manage them, in my view. You know, I wouldn’t be able to manage something like that.
And if I read a 10K that’s 300 pages long and it describes notional values and all this – not to impugn anybody because probably one of the best managed, really large institutions around – but if I look at JPMorgan, I see two trillion of receivables, two trillion of payables, a trillion seven netted off on each side; of the 300 billion remaining, maybe 200 billion collateralized.
But that’s all fine, but I don’t know what these continuities are going to do to those numbers overnight. If there’s a major nuclear, chemical, or biological terrorist action that really is disruptive of the whole financial system here, who the hell knows what happens to those numbers on both sides or thousands of counterparties around?
So I don’t think it’s – I think it’s virtually unmanageable. It certainly is – it would be for me.”
The causes of the housing crisis that led to the financial crisis:
“Well, I think the primary cause was an almost universal belief, among everybody and I don’t ascribe particular blame to any part of it – whether it’s Congress, media, regulators, homeowners, mortgage bankers, Wall Street — everybody — that houses prices would go up. And you apply that to a $22 trillion asset class, that’s leveraged up, in many cases. And when that goes wrong, you’re going to have all kinds of consequences.
And it’s going to hit not only the people that did the unsound things, but to some extent the people that did the semi sound, and then finally the sound things, even, if it is allowed to gather enough momentum of its own on the downside, the same kind of momentum it had on the upside.
I think contributing to that — or causing the bubble to pop even louder, and maybe even to blow it up some, was improper incentives — systems and leverage. I mean, those — but they will contribute to almost any bubble that you have, you know, whether it’s the Internet or anything else.
The incentive systems during the Internet, you know, were terrible. I mean, you just — you formed a company, and you said, “I’m going to somehow deliver a billion eyeballs,” and somebody says, “Well, that’s $50 apiece,” or something. I mean, you get craziness that goes on there.
Leverage was not as much a factor in a bubble. But I think in this particular bubble, because leverage is so much a part of real estate, that once you loosened up on that, you’ve provided fuel that caused that bubble to get even bigger, and you made the pop even bigger, when it finally did pop.”
Accepting but not condoning fraud:
“Well, I mean, there was, obviously, a lot of fraud. There was fraud on the parts of the borrowers and there was frauds on the part of the intermediaries, in some cases. But you’d better not have a system that is dependent on the absence of fraud. I mean, it will be with us.”
Here’s the link to download the transcript of Buffett’s interview. Take a look. Trust me – you’ll thoroughly enjoy it.
Photo source: Modified from Warren Buffett Caricature by DonkeyHotey under Creative Commons 2.0.
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