10 Highlights of the Financial Crisis Inquiry Commission Interview of Warren Buffett on May 26, 2010
The recently released 103 page transcript of the Financial Crisis Inquiry Commission Interview of Warren Buffett on May 26, 2010 provided some very interesting insights into the causes of the financial crisis, its consequences on the shareholders of financial institutions, and on stock market valuation.
(1) Stock Market Valuation – Mr Buffett cites a 1924 book by Edgar Lawrence Smith that concluded that stocks always outperform bonds “when the dividend yield on stocks was the same as the yield on bonds, and on top of it you had retained earnings.” If we were to apply this rule of thumb to today’s stock market, the current dividend yield on the S&P 500 of 2.12% exceeds the yield on 10-year U.S. Treasury bond (1.72%), as of the market close on April 8, 2016. Furthermore, a better measure, the earnings yield of the S&P 500 (inverse of the P/E ratio) equals 4.43%. By these measures, stocks should be expected to outperform bonds, at least in the short or intermediate term.
(2) Bubbles – The housing bubble resulted from the almost universal expectation that the prices of houses can only go up.
(3) Smoothing Earnings – Warren Buffett sold his major stake in Freddie Mac (FRE) when management promised steady earnings growth. This implied potential manipulation of accounting in order to achieve this goal in a cyclical economy. FRE was also starting to invest in the bond of a major tobacco company which had nothing to do with its mission of promoting home ownership.
(4) Moral Hazard – When the Federal Government stepped in to assist many financial institutions through TARP, etc., the shareholders of these companies lost between 90 and 100% of their investment. Bear Stearns stock went from 180 down to 10. This assistance was required to restore confidence in the financial system. Those who criticized the government’s actions on grounds of “moral hazard” were wrong, as the equity of these firms was essentially wiped out. Unfortunately, wealthy CEO’s were able to walk away while being able to maintain the bulk of their wealth. Mr. Buffett recommends that any company that requires financial aid from the U.S Government should have the wealth of the CEO and his/her spouse wiped out.
(5) Derivatives – Derivatives injected enormous leverage and counterparty risk. The more complex and opaque the derivative, the more profitable it was sell. Lehman had a large derivative book with numerous counterparties.
(6) Leverage – If you do not have leverage, you do not get into trouble. Leverage is the only way a smart person can go broke. If you are smart, you do not need it, and if you are dumb, you should not be using it.
(7) Econometric Models – Models work 98% of the time. They never work 100% of the time.
(8) Opaque – If an investment is opaque, walk away.
(9) Ken Lewis – If Ken Lewis (Bank of America) had not bought Merrill Lynch, the financial system would have collapsed.
(10) United States vs. Europe – In the U.S. during the financial crisis we saved ourselves. By contrast, European countries faced the dilemma of saving other countries.
Mr. Buffett’s point about the misplaced concerns about Moral Hazard (#4) is vital to understand if the U.S. Is ever going to get past the simmering anger about “big [mega] banks”. The mega-banks are corporations; and, as the late US Supreme Court justice Antonin Scalia once wrote, corporations are “tongue-less abstractions.” Abstractions cannot cause financial harm; but banking executives — many of whom should have been permanently banned from the industry by federal regulators — certainly made their contribution to the national pain. Today, blaming “banks” as a national scapegoat is a fool’s errand. A bank is nothing more than a collection of legal documents (Scalia’s tongue-less abstraction); it is the executive management — breathing individuals — that are either deserving of derision or delight.
If regulators force the spinoff of a mega-bank into five smaller entities, but the five most culpable managers from the megabank are made the five CEOs of the spinoff companies, no problem has been solved. But keep the megabank and make the executives personally accountable (need government assistance, fine, but it’s zero net worth for you and the spouse … Per Warren Buffett), then you solve a national problem.