Warren Buffett’s annual letter to shareholders offers plenty of investing insight, and we encourage you to follow our colleagues at WSJ.com as they dissect it. At Real Time Economics, we take particular interest in Mr. Buffett’s view of the economy and government policy.
Buffet has insight into the economy. (Associated Press) It’s hardly shocking that Mr. Buffett would believe the economy, gripped by fear, “will be in shambles throughout 2009.” What he tacked onto that assessment — “and, for that matter, probably well beyond” — is troubling for the lack of any near-term optimism. But it’s also not a surprise. (The great investor notes that his assessment of the economy “does not tell us whether the stock market will rise or fall.” Some of his readers might hope for the market to just remain flat for now.)
Mr. Buffett at times praises the Federal Reserve and other wings of the U.S. government for their response to the crisis. In a discussion of the derivatives “time bomb,” for instance, he supports Tim Geithner — “then the able president of the New York Fed” — for preventing Bear Stearns’s failure and avoiding a financial collapse by chain reaction. “In my opinion, the Fed was right to do so,” Mr. Buffett says.
But his assessment of what the central bank response will create over the long term — a likely “onslaught of inflation” — may cause some heartburn in the months ahead for Fed Chairman Ben Bernanke and other officials who are trying to argue they can withdraw their many programs when they need to. While Mr. Buffett clearly backs most of the government response, he doesn’t think the exit will be easy.
Here’s Mr. Buffett’s precise wording in full:
“This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone ‘all in.’ Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.
“Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly. Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.”
Mr. Buffett is quick to note that “our country has faced far worse travails in the past” with a dozen panics and recessions in the 20th century, “virulent inflation” in 1980 and, of course, the Great Depression in the 1930s.
“Without fail, however, we’ve overcome them,” he writes. “In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time.
Buffet has insight into the economy. (Associated Press) It’s hardly shocking that Mr. Buffett would believe the economy, gripped by fear, “will be in shambles throughout 2009.” What he tacked onto that assessment — “and, for that matter, probably well beyond” — is troubling for the lack of any near-term optimism. But it’s also not a surprise. (The great investor notes that his assessment of the economy “does not tell us whether the stock market will rise or fall.” Some of his readers might hope for the market to just remain flat for now.)
Mr. Buffett at times praises the Federal Reserve and other wings of the U.S. government for their response to the crisis. In a discussion of the derivatives “time bomb,” for instance, he supports Tim Geithner — “then the able president of the New York Fed” — for preventing Bear Stearns’s failure and avoiding a financial collapse by chain reaction. “In my opinion, the Fed was right to do so,” Mr. Buffett says.
But his assessment of what the central bank response will create over the long term — a likely “onslaught of inflation” — may cause some heartburn in the months ahead for Fed Chairman Ben Bernanke and other officials who are trying to argue they can withdraw their many programs when they need to. While Mr. Buffett clearly backs most of the government response, he doesn’t think the exit will be easy.
Here’s Mr. Buffett’s precise wording in full:
“This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone ‘all in.’ Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.
“Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly. Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.”
Mr. Buffett is quick to note that “our country has faced far worse travails in the past” with a dozen panics and recessions in the 20th century, “virulent inflation” in 1980 and, of course, the Great Depression in the 1930s.
“Without fail, however, we’ve overcome them,” he writes. “In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time.
It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.”
Among the many other notable points in the letter:
* On homeownership, Mr. Buffett says the housing mess teaches that home purchases should require “an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income.” That income must be verified, of course. “Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective. Keeping them in their homes should be the ambition.”
* He says the lending operation of Clayton Homes, the largest player in the manufactured-home industry, is being threatened by having to compete with funders that have worse credit than Berkshire Hathaway. Firms that are backed by government guarantees — banks with FDIC support, issuers of commercial paper backed by the Fed, and others getting themselves under the government umbrella — have “minimal” money costs, Mr. Buffett says. Highly-rated firms such as AAA-rated Berkshire face record borrowing costs in relation to Treasury rates.
At the same time, funds are “abundant” for government-backed borrowers but “scarce” for others. “This unprecedented ’spread’ in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status,” he writes. “Government is determining the ‘haves’ and ‘have- nots."
* We’re now in a world of overpricing risk rather than underpricing it, pushing yields up for municipal or corporate bonds and knocking them down to near zero for short-term government bonds “and no better than a pittance” for long-term government securities. “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. Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long.”
* Mr. Buffett rails against derivatives, which increased risks to the financial system and “made it almost impossible” to understand the largest commercial and investment banks. He devotes considerable attention to knocking Fannie Mae and Freddie Mac and how derivatives allowed the mortgage giants to misstate earnings for years. He takes repeated jabs at their regulator, then the Office of Federal Housing Enterprise Oversight (now the Federal Housing Finance Agency), for taking so long to recognize the problems at the firms.
* And we can’t leave you without sharing Mr. Buffett’s description of the troubles entailed in settling derivatives contracts. Settlements can take years or decades — while stocks take just three days — and the lengthy periods build up counterparty risk.
Mr. Buffett writes: “Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with.
Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it assures them government aid if trouble hits. In other words, only companies having problems that can infect the entire neighborhood – I won’t mention names – are certain to become a concern of the state (an outcome, I’m sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won’t do; it’s mindboggling screw-ups that are required.”
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