Whether Buffett and I are fools – well I will leave that for others to decide.

From Bronte Capital:

"Fools seldom differ

Warren Buffett was on CNBC last night. Maybe he is getting old and vain and likes to be on TV. Maybe he is falling for the (considerable) charms of Becky Quick – but he allowed himself to be interviewed for three hours starting at 5am Omaha time.

That made it good evening TV for me in Sydney Australia.

I was amused to hear my own views – parroted back to me in a more articulate and folksy manner than this blog.

There is a saying – usually ironic – that “great minds think alike”. I immediately think of the come-back that “fools seldom differ”.

Whether Buffett and I are fools – well I will leave that for others to decide. However Joe Kernan (and not the dulcet Becky) got out of Buffett what I believe to be the money quote of the whole interview:

BUFFETT: Yeah, the interesting thing is that the toxic assets [of American banks is] if they're priced at market, are probably the best assets the banks has, because those toxic assets presently are being priced based on unleveraged buyers buying a fairly speculative asset. So the returns from this market value are probably better than almost anything else, assuming they've got a market-to-market value, you know, they have the best prospects for return going forward of anything the banks own. The problems of the banks are overwhelmingly not toxic assets, you know. They may have been one or two at the top banks, but they are not going to do in--if you take those 20 banks that are subject to the stresses, they're not going to do those banks in. Those banks have the earning power which has never been better on new business going out of this to build capital positions if they pay low dividends which they're starting to do now.

JOE: Hm.

BUFFETT: Toxic assets really are not the problem they were. Now, when I said it was contingent--I didn't remember being exactly contingent on TARP, but it was contingent on the government jumping in.

JOE: Right.

BUFFETT: The government needed to act big time in September, I will tell you that.

JOE: So...

BUFFETT: And they did act big time.

JOE: So you are OK with the shift to providing the banks with capital as opposed to the original intention of the TARP for actually getting the toxic assets off the books?

BUFFETT: Yeah, and interestingly enough, they don't need to supply the banks, in my view, with lots of capital. They need to let almost all of--I mean, the right prescription with most of the banks is just let them pay very little in the way of dividends and build up capital for awhile, and they will build up a lot of capital. The government has needed to say--what the government needs to say is nobody's going to lose a dime by having their deposits in these banks. They're going to make lots of money with the deposits.

JOE: Hm.

BUFFETT: The spreads have never been wider. This is a great time to be in banking, you know, if you just get past the past and they are getting past the past. I mean, right now every time a loan is made to somebody to buy a house--and we're making, you know, making millions of loans--four and a half million houses will change hands this year out of a total stock of less than 80 million. So those people are making good mortgages. You want those assets on your books and you get a great spread in putting them on now. So it's a great time to be in banking, but you do have to get past this past. But the toxic assets, in my view, you know, if they've been written down to market, I'd rather buy those assets from the bank than any other assets they've got.

JOE: Hm. OK...

Lets pick this apart: Warren Buffett has been saying that the toxic assets are the best assets of the bank (provided they are marked to market). This is precisely what I have been saying. Moreover he says it for precisely the same reasons that I do – which is that they are being priced based on “unleveraged buyers” buying a fairly speculative asset. Compare this to my explanation in the “long post” – which was that they had large yields because you could not borrow to buy them.

Then Buffet says that the returns from the toxic assets are better than almost anything else. Several people (including some high profile academic economists) disagreed with me about the spread on those assets. That is fine – they are also disagreeing with Warren. He is wrong fairly regularly too.

Then he says the problem of American banks are not overwhelmingly toxic assets. This is a radical view – but it is in my view correct. The problem with the banks is that nobody will trust them and they have not been able to raise funds. The view that this is a liquidity crisis – and not a solvency crisis – has long been a staple of the Bronte Capital blog. It is radical though. Krugman, Naked Capitalism and Felix Salmon think alike – asserting – seemingly without proof – that the problem is solvency. Buffett doesn’t even think the US banks (on average) require capital – a view that most people would find startling (though again I think is correct provided appropriate regulatory forbearance is given).

Moreover Buffett thinks it is not solvency for the same reason as me. To quote: “those banks [including presumably most of the big 20 banks in the US] have earning power which has never been better on new business going out of this to build capital positions even if they pay low dividends which they're starting to do now.” I have been criticised endlessly for pointing out that on pre-tax, pre-provision earnings American banks can quickly regain solvency provided they can maintain funding. This was the point of my Voodoo Maths post – and also the point of much of the long post.

Moreover he goes on to repeat that the opportunities in banking are simply wonderful now – so long as you can get past the past. This was the point in my series of posts on Bank of America’s quarterly numbers. To anyone that looks at the American numbers it is self-evident that the margins in banking are going up sharply and that the opportunities are large right now. However this simple observation set my inbox on fire – to the point that I felt I needed four posts (links 1, 2, 3, and 4) to defend the obvious.

(Incidentally the margin expansion is not evident in the UK – where the banks are properly insolvent – and it is not evident in France where the banks are almost certainly highly solvent. I can’t work out why it is not in evidence in France but if someone wants to explain it send me an email. I would be pleased.)

There were other parts of the interview where Buffett simply agreed with me. For instance he thinks that bank liabilities should simply be guaranteed at this point (at least for the large banks) and that guarantee should carry the personal weight of the President. The alternative is either endless government injections costing as much as the guarantees or uncontrolled liquidation –a dozen Lehmans - as the banks run out of funding. They did issue guarantees in Sweden – and I was hoping and praying that the US would become Swedish.

Krugman is finally coming to the view that the important technical question is whether to issue that guarantee. He is right. Provided the guarantees can be issued at reasonable cost they should be issued. Both Warren and I think the cost would be reasonable in the USA. By contrast I am not sure the UK has the blanket guarantee option because the UK banks are very large relative to the UK economy and they started highly capital inadequate. US banks by contrast started with a lot of capital.

Buffett did not approach the issue of how you treat banks after you have issued that guarantee. I think you should have a process for assessing their capital and require that they have sufficient. Those that do not have sufficient and can't raise it you should nationalise (by diluting the shareholders and preference shares out of existence). That was the point of my “nationalisation after due process” post. Though the nationalisation question is entirely secondary to the question of whether you treat this like a liquidity crunch (by guaranteeing liquidity) or whether you treat it like a solvency crunch (by forcing insolvent banks to liquidation). I know which side I am on – and it is the same side as Warren.

Now it is all very nice to be demonstrably thinking the same way as Warren Buffett. I should have an operating funds management business after I get through complexities of Australian licensing and similar hurdles. If people widely believed that I thought like Warren I would be inundated with money – and that would be a good thing – at least for me.

But I have to note that Warren was not entirely straight forward in the interview. Warren did not think he could get the preference share deals he got from GE or Goldman Sachs now. That might be true with Goldies – but it was unequivocally false with GE. With GE you could construct a better deal on market.

This blog (painfully) admits its mistakes and tries to analyse them. A money manager should be brutally honest with himself. Warren however is an old man and his credibility is harder to question that mine. But Warren was wrong with his GE preferred (if only because he could get a better deal later). He should have admitted that (at a minimum) his timing on that one was awry.

It would be inordinate vanity to hope that I will be better than Warren. But I hope at least to think clearly and rationally like him. Oh, and to hold myself to a decent standard of self-analysis and criticism when I stuff up.

John

Posted by John Hempton at 3:48 PM

Me:

Don said...

Just a few points:

"The government has needed to say--what the government needs to say is nobody's going to lose a dime by having their deposits in these banks."

"For instance he thinks that bank liabilities should simply be guaranteed at this point (at least for the large banks) and that guarantee should carry the personal weight of the President."

In order to end Debt-Deflation, the government has to issue such a guarantee. I believe that they have done that. It's not a question of the guarantees any more, but the cheapest and best way to spend our money. We're going to spend whatever is necessary. In my mind, their actions, if not their words, prove that.

"Moreover he goes on to repeat that the opportunities in banking are simply wonderful now – so long as you can get past the past."

Buffett is a follower of Graham, I believe. I'm not a big investor, but I follow most of Graham's views. There is no doubt that there are good investments in Toxic Assets, Corporate Bonds ( Junk ), Distressed Equities, and that a downturn is generally a good place to buy. But it is awfully hard to do, and you do need to look at each specific case.So, given his investment philosophy, Buffett is saying what I would expect him say, more or less.

"Yeah, and interestingly enough, they don't need to supply the banks, in my view, with lots of capital."

I know that you went to great pains to discuss insolvency, but most people assume that, if you NEED money or a loan, you're insolvent. Otherwise, why in hell is the government giving them money? To the extent that the government provides funds or subsidies, taxpayers will assume that the borrowers are insolvent, otherwise, they shouldn't be getting any money from us.This is especially true if they don't use the money for more loans, even if that's not a good idea. In other words, I don't think that you can get away from selling this aid as a solvency crisis, even though that has the effect of making calls for nationalization stronger.

Don the libertarian Democrat

Only post this if you think it adds anything to the debate.

March 11, 2009 6:38 AM