Tuesday, March 3, 2009

“In God we trust; all others pay cash.” – Berkshire’s annual letter to Shareholder’s

The annual letter by Warren Buffet was sent to Shareholder's over the weekend. For investors, Buffett's letter is always welcome and an interesting read. Buffett is a liberal, but he is also one of the most knowledgeable minds in the investing world. Buffett's letter not only gives the state of affairs on Berkshire Hathaway, Buffett's company, but it is very instructive on the economy. Buffett was prescient when he called the derivative debacle for what it was, "Weapons of Financial Destruction" years before the current housing crisis. Buffett's annual letter to shareholder can actually move markets.

Buffett uses analogies to convey his message. Investors Buffett wrote "were bloodied and confused, much as if they were small birds that had strayed into a badminton game." That sure sums up me. Buffett believes that the massive bailouts of the banks were necessary to prevent a total collapse. Wall Street, Main Street and everyone else were all in the same boat. The one likely consequence of this bailout and the massive spending by the current administration is the onslaught of inflation.

Buffet makes the observation that in spite of World Wars, The Great Depression, etc, the standard of living for Americans has improved seven fold since the 1900s, and the Dow Jones Industrial has risen 66 to 11,497 (of course now it sits at 6,793). Buffett says our best days lie ahead, but I say it won't be until after Obama is dethroned. Buffett then went on to say, "In our usual opinionated view…we're certain that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall." Of course, I am not sure how he arrives at that conclusion since the stock market is reflective of the economy.

Pessimism is your friend, Euphoria is the enemy says Buffet, and then he continues with one of his analogies. I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly taking action. Buffett says one of these mistakes was his purchase of ConocoPhillips.

Buffett talks about the mortgage crisis, 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. Buffett observes that the current housing crisis did not occur because a house is worth less than its mortgage, although that is indeed the case in many situations. When a homeowner makes a meaningful down-payment that he/she obtained from savings and not from borrowing seldom walks away if the house falls in value. In the current debacle, homeowners counted on further price appreciation that they could either flip or refinance to extricate themselves from their situation, hence the problem. Lenders happily made loans borrowers couldn't repay out of their incomes, and borrowers just as happily signed up to meet those payments. Home purchases should involve 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 should be carefully verified. Keeping people in their homes not putting them in their homes should be the country's objective. In other words, not everyone should be in a home. If you haven't seen MSNBC's House of Cards, I recommend you watch it.

Derivatives were another subject which Buffett wrote about in great detail. Derivatives were what allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years. Freddie Mac and Fannie Mae were so indecipherable that their federal regulator OFHEO who had more than 100 employees had only one job, overseeing Fannie Mae and Freddie Mac. In spite of it all, they completely missed their cooking of the books. In 2006 OFHEO issued a 340 page report detailing the malfeasance of Fannie Mae and Freddie Mac blaming the fiasco on both parties, but not congress and the OFHEO. CEOs were unable to manage a business with the complex instruments known as derivatives. Buffett talks about how he and his partner could not understand these derivatives, so when he decided he could not get a handle on them, he closed up shop on General Re in 1998 because of their 23,218 derivatives. He quoted a line in a country song in reference to the derivatives, "I liked you before I got to know you so well."

Improved transparency won't help these derivatives says Buffett. Auditors can't audit these contracts and regulators can't regulate them. Buffett says, "When I read the pages of 'disclosure' in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don't know what is going on in their portfolios, and I reach for the aspirin." If Warren Buffett, cannot understand these derivative instruments, no one else will be able to understand them. CEOs who continue to leverage their business sometimes in excess of fifty times and run huge books on incomprehensible derivatives, Buffett states the following, "Modest incompetence simply won't do, it's mindboggling screw-ups that are required."

My Thoughts

The housing crisis was of course the impetus to this current debacle, but there is a more pernicious event unfolding - the failure of the administration in understanding what makes economies grow The market needs to have confidence, but it doesn't, there is a crisis in confidence,, and the market is reflective of business and the business environment. We have seen the effects in California with out of control spending and high taxes, and we will soon see the results of even higher taxes on the Golden state. The Dow sits at 6,793. On November 4th, the Dow stood at 9,654, a 2861 point decline, a 30% drop since Obama was elected. If the market has confidence in an incoming president, you would see market rallies even if the economy were sitting in the doldrums. The president can give confidence to the market if he so desires. The market has continued a downward spiral. Whenever Geithner, Obama, or someone else from the administration speaks, the Dow falls. The market looks at the economy but it also looks at the current administration. The investor class is not dumb.

The AP writes:

While tackling the economic crisis, he is asking Congress to enact contentious measures that have been debated, but not decided, in calmer times: cut subsidies for big farms; combat global warming with a pollution tax on industries; raise taxes on the wealthy; make big changes to health care, including lower reimbursements for Medicare and Medicaid treatments and prescription drugs.

Standing alone, any one of these proposals would trigger a brawl in Congress and fierce debates outside Washington. Obama wants the proposals done largely in concert, as an interrelated plan to undo major elements of Ronald Reagan's conservative movement.

And the Wall Street Journal notes the following:

Americans have welcomed the Obama era in the same spirit of hope the President campaigned on. But after five weeks in office, it's become clear that Mr. Obama's policies are slowing, if not stopping, what would otherwise be the normal process of economic recovery. From punishing business to squandering scarce national public resources, Team Obama is creating more uncertainty and less confidence -- and thus a longer period of recession or subpar growth

The market became afraid of an Obama presidency when he began to rise in the polls because of his anti-business rhetoric he espoused during the campaign. After his election, there were two factions of conservatives, those that said (or at least hoped) that he would be a moderate or a centrist, and the other faction who said he would lead as a radical. I was of the latter because that is what his history suggested, and he didn't disappoint, (I was hoping he would.) Thus far, he has spent a trillion dollars in stimulus pork soon to be followed by more. He intends to increase the tax on those who create the jobs, those making $250,000 dollars or more a year, (those who make over 200K already pay 60% of the taxes) and he intends to raise the capital gains rate to 20%. He has begun to create protectionist policies using a "buy provision" in the stimulus bill which will inevitably hurt trade and he will begin a cap and trade scheme whose effect will be to stifle economic growth and make us globally non-competitive. This, of course, is only the beginning. Investors will sit on their cash awaiting better times ahead. You cannot expect to have a healthy economy when you suck the very capital out of the people who create the jobs or do the investing. I never thought I would be nostalgic for Bill Clinton. Obama has proven to be the radical he is – he in effect has declared war on capitalism. God help us all.


muckdog said...

And what if energy prices go up? Everyone seems to have forgotten the other thing that led us into the recession. $147 oil.

Wouldn't take much to get it back up there.

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