THE ORACLE OF OMAHA SPEAKS

Berkshire Hathaway, the company chaired by Warren Buffet, released its annual report today.  Mr. Buffet's annual letter to stockholders is always a good read, if not prescient.  Because the letter is dense and has many topics, this post will be longer than usual, but it is worth it.  

Buffet noted that the US economy is in shambles:

"We're certain, for example, that the economy will remain 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."

And we are not out of the woods.  Whether the market will yield investable opportunities or not is unknown, even in a downward spiraling economy; however, Buffet offered these words of wisdom:  "When investing, pessimism is your friend, euphoria the enemy."

The government is taking acts to give the appearance that it is taking acts to help the economy, but no one really knows if these actions will work.  We do know that they didn't work during the great depression and they didn't work in Japan.  Nevertheless, we do know that the  government solutions will have unwelcome aftereffects.  Buffet said:

"The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear. 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."

Aside from inflation, the government spending is making private industries, and municipalities dependent upon government aid.

"[M]ajor 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."

In other words, be prepared for continuing this extreme level of wealth redistribution far into the future.  Just think how long it has taken us to dismantle the temporary solutions put in place by FDR to get us through the depths of the great depression. (Hint: Those Programs Still Exist.)

What is worse, the government is playing favorites.  After years of trying to level the playing field among various financial institutions (on the theory that competition helps consumers and the economy), the administration's bailout is playing favorites by giving  insolvent banks money at lower cost than banks that didn't act irresponsibly.

"Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be. 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. Government is determining the “haves” and “have-nots.” "

In other words, our government is rewarding bad economic policy.  It is the same  wrong headed message we send when we tell people that if they borrowed money to buy a house, the government will step in to pay the mortgage when the borrower can't pay.  Here we are telling banks that if they make bad loans and become insolvent, instead of letting the banks fail, we will give them a competitive advantage over other banks and lenders by giving them money below market cost.   

Berkshire Hathaway also has a division that is involved in housing, mainly through manufactured homes.  While not immune from credit risk, Buffet's company is in a far better position to weather the storm because of sensible lending practices. 

Here is what Buffet had to say:

Commentary about the current housing crisis often ignores the crucial fact that most foreclosures do not occur because a house is worth less than its mortgage (so-called “upside-down” loans). Rather, foreclosures take place because borrowers can’t pay the monthly payment that they agreed to pay. Homeowners who have made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away from a primary residence simply because its value today is less than the mortgage. Instead, they walk when they can’t make the monthly payments. 

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The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. 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. 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.

There are many more tidbits in the annual report, but this post is lengthy enough so I will move on.  Please go to the Berkshire Hathaway site to read the entire annual report.  Enjoy the read.