Friday, May 14, 2010

2010 Pilgrimage, Part II: “A Closer Call” than Buffett Thinks…and Yes, Charlie Did Say “Scuzzy”


“I think the central part of the argument is that Paulson knew more than the bond people….They [the bond people] just made what in retrospect turned out to be a dumb insurance decision.”

So Warren Buffett frames the SEC complaint against Goldman Sachs & Company in the now-infamous ABACUS transaction, and summarizes his defense of that now-tarnished investment bank in front of 17,000 Berkshire shareholders here at the Qwest Center arena in Omaha (and another 15,000 scattered in other rooms watching on monitors elsewhere.)

“ABACUS,” we should add, for readers whose eyes start to glaze over when they see Wall Street deals with testosterone-charged names, was merely a bet by one smart guy—hedge fund manager John Paulson—that a bunch of mortgages would fail.

Paulson helped pick some of those mortgages, and Goldman Sachs & Company packaged those bets and sold them to IBK, a small German bank—all with the blessing of ACA, the supposedly independent third-party bond insurer enlisted by Goldman for the purpose.

Buffett continues his defense, along the lines of ‘let the buyer beware,’ by using a typically Buffettian analogy to bring the thing home for his shareholders:

“Let’s say we had decided to short the housing market in early 2007…I don’t think anybody should blame us.”

With that, Warren Buffett has just done something cagey. Smart, but cagey.

By identifying “the central part of the argument” as John Paulson’s behavior, Buffett has turned the spotlight away from Goldman Sachs & Company’s behavior and on John Paulson’s behavior. Yet nobody—not even the SEC—is claiming that Paulson did anything wrong.

Paulson simply bet that a bunch of old nags (mortgages to people who couldn’t afford them) gussied up like thoroughbreds would keel over and die before they got around the race track. And Paulson won—big-time—at the expense of IBK.

But it is not likely he could have accomplished it on the scale he did without the aid of Goldman Sachs and dumb bond insurers like ACA.

Having thus deflected the issue away from Goldman, Buffett then turns the question over to Berkshire’s Vice-Chairman, Charlie Munger. “Charlie?”

Munger, as is his wont, has been sitting patiently, pouring a glass of ice water for himself and gazing out at the crowd through his Coke-bottle thick glasses while Buffett expounds on Goldman Sachs, John Paulson and the ignoramuses at ACA.

Before he can being, Buffett reminds the audience of something relevant to the discussion: “Charlie has a law degree.”

And in fact Munger started his path to the Forbes 400 not by peddling stocks in his father’s brokerage firm, as did Buffett. Instead, Munger took his Harvard law degree to Los Angeles—where he had been stationed during World War II—and founded Munger, Tolles & Olson LLP.

It was in his capacity as an attorney advising a variety of companies that Munger grasped an important truth which even Warren Buffett hadn’t grasped as a Ben Graham value-maven looking for cheap stocks in the Moody’s manual: it is better to buy a fantastic business at a good price than a bad business at a fantastic price.

That lesson helped create Berkshire Hathaway as we know it, and it underlies the reason Berkshire shareholders have been sitting through a half hour worth of Buffett’s flag-waving defense of Goldman Sachs & Company.

For the investment banking business is not necessarily a fantastic business on its own: it requires fantastic management. As Andrew Ross Sorkin quotes Buffett (in the excellent “Too Big to Fail”) telling Goldman CEO Lloyd Blankfein, “If I’m buying the horse, I’m buying the jockey, too.”

And the Goldman jockeys are under fire.

Munger clears his throat and leans towards the microphone in his deliberate, understated manner, and leads with a reference to the recent revelation that SEC commissioners voted 3-2 to pursue the Goldman case, and were split along party lines.

“This was a 3-2 decision,” Munger says. “If I had been on the SEC I would have been on the minority too.”

This generates a groundswell of good feeling towards Buffett’s defense of Goldman, and Buffett jumps in with another couple of daggers to stock into ACA’s hide:

“I have seen ACA referred to as investor…ACA was a bond insurer, pure and simple—very simple as it turned out.”

Speaking over the ensuing laughter, Buffett prompts Loomis for the next part of the question. “Carol?”

“The next part,” Loomis says, “was, ‘your reflections in light of Berkshire’s large investment in Goldman…’”

This gives Buffett a chance to gloat about Berkshire’s investment in Goldman, which was made during the crisis days of 2008 when the entire financial world look close to falling apart. Buffett invested $5 billion for a fat, dividend-paying preferred, plus warrants to buy Goldman shares for Berkshire’s—and he doesn’t want to give them up.

“Very ironically it’s probably helped our investment in Goldman,” he says. “Our preferred pays us $500 million a year,” and Buffett notes that Goldman has a legal right to pay off the preferred any time it wants, at a 10% premium to Berkshire’s cost.

“If we got that $5.5 billion today we’d put it in very short term securities which might produce $20 million or something”—quite a few dollars less than the $500 million Berkshire is getting from the preferred. “Our preferred is paying us $15 a second. Tick, tick, tick, that’s $15 a second…I don’t want those ticks to go away…they pay me at night, on weekends…”


This generates guffaws, and Buffett—like a comic who knows a good line when he hears the laughs—keeps riffing on that theme while pointing out that the Federal government has been pressuring investment banks to keep as much capital on their books as possible, meaning Goldman probably would be hesitant to repay the Berkshire investment too soon:

“They [the Feds] have been pretty strong with all the TARP companies that they could not pay dividends…and I was just hoping they’d continue to be tough in not letting Goldman call our preferred. ‘Tick tick tick’ will go on so that we will be getting $500 million a year instead of $20 million. We love the investment.”

The audience, likewise, loves the greedy capitalist routine.

When it comes to “losing reputation,” however, Buffett draws what must surely be the weakest quiver from his quiver. Buffett is, after all, almost as famous for the high standard of behavior to which he holds Berkshire managers as he is for making money:

We can afford to lose money—even a lot of money. We cannot afford to lose reputation—even a shred of reputation. Let’s be sure that everything we do in business can be reported on the front page of a national newspaper….Berkshire’s results have benefited from its reputation, and we don’t want to do anything that in any way can tarnish it.

—Warren E. Buffett, memo to Berkshire Managers, August 2, 2000


Leaving aside the obvious fact that Goldman’s successful effort to pawn off some lousy mortgage bets on one customer at the behest of another has resulted in plenty of terrible front page stories on every national newspaper left standing (and their web sites, too), Goldman’s reputation is in no way, shape or form what it was before the details of ABACUS were made public.

Yet Buffett—who, as a student of the Dale Carnegie method of winning friends and influencing people, almost never criticizes individuals in public—answers by first offering a bit of a history lesson. Ancient history, for this crowd:

“Losing reputation—there’s no question the press of the last few weeks can hurt moral…it hurts. Incidentally, Goldman Sachs had a situation with the Penn Central years ago…it was a source of great pain to John Weinberg…”

Penn Central was a railroad that went spectacularly bankrupt in 1970, triggering an SEC investigation and civil fraud suits in 1974. Among those investigated was Goldman Sachs, whose CEO was the aforementioned John Weinberg.

Here’s how Time Magazine described, in 1974, Goldman’s role in the affair, which sounds eerily familiar 35 years later:

Goldman Sachs insists that it did nothing wrong in marketing $83 million of commercial paper for Penn Central in the six months before the bankruptcy. But it signed a consent decree under which it promised that it will investigate companies for which it sells commercial paper and tell would-be buyers what it finds out.Buffett, who can see the forest for the trees better than most investors, knows that Goldman Sachs will, ultimately, work through the current bad press, not to mention the efforts of Congresspersons everywhere to look less incompetent themselves by ganging up on Goldman Sachs.

But he uses that long-term view as the means to insist that what Goldman did was not, somehow, a violation of the ‘front page of the newspaper’ standard he himself uses for Berkshire managers:

“I don’t believe the allegation belongs in the category of losing reputation.”

Yet he’s been proven wrong on this one before the doors opened this morning.

As for “advice” he would give to Goldman Sachs, Buffett cites “our motto” when he and Charlie were working hard to rescue Salomon Brothers during their scandal of more than two decades past:

“Get it right, get it fast, get it over with.”

He then allows himself a significant loophole that might make today’s defense null and void:

“If it leads into something more serious then we’ll look at the situation at that time.”

Before handing off the reputational question to Munger, Buffett finishes up by repeating his central argument:

“But what I’ve seen of the ABACUS activity I don’t see that would be any different from me complaining of that list of municipals. Charlie?”

Munger stirs and says words that are undoubtedly on everyone’s mind here today—and what most of us very likely expected Buffett to say when it came to Goldman Sachs:


“I agree with that but I think a lot of companies should decline business that would be legal…the standard should not be ‘what’s legal and convenient.’”

That draws an appreciative murmur: it seems exactly right. Munger then offers a backhanded defense of Goldman Sachs:

“I don’t think there are too many investment banks that didn’t do scuzzy deals.”

(Yes, Charlie Munger—one of the most erudite and literate investors in the word, did say ‘scuzzy.’)

But now it gets really interesting, for Buffett’s ear is sharply tuned to Munger’s words, and he wants to follow up on them. This is no mere crowd-pleasing aspect to their performance. The two men not only listen to their shareholder’s questions carefully, but they listen to each other the same way.

And if one says something the other disagrees with or wants to clarify, he will follow up in front of 17,000 people.

Thus Buffett follows up on Munger’s lumping of the entire category of credit-bubble-era investment banks together as “scuzzy” with a question about Berkshire’s own participation in the excesses of that era—the municipal bond deal brought to Berkshire by “another carny,” Lehman Brothers, which Warren Buffett and Ajit Jain agreed to insure:

“But Charlie,” he asks, “do you think we should have done our municipal bond deal?”

Munger, who may or may not be the only person in the world that doesn’t think twice about disagreeing with Warren Buffett, says without hesitation,

“I think it was closer call than you do.”

And many of the Berkshire Hathaway here will agree with “Charlie,” as it turns out.

To be continued…



Jeff Matthews
I Am Not Making This Up


© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

5 comments:

Kieran McCarthy said...

Wow. That's great. Buffett's the better investor, for sure, but Charlie's a better read and more interesting human being, in my opinion. The "Psychology of Human Misjudgment" is among the best short treatises I've read. As an erstwhile philosophy major, I don't hesitate to put it in the same category as the Classics.

Brian said...

It does seem if Buffett has a self-interested selectivity when it comes to reputation -- when the reputation of his companies or investments has not been damaged, it matters.

My take on the Goldman ABACUS deal is that it is indeed "scuzzy", but I would go further and think that it does cross the line to fraudulent on Goldman's part.

Like you point out, nobody has accused John Paulson of anything illegal, as they had no fiduciary duty to anyone outside of themselves. Buffett, and many Goldman defenders, focus on the fact that ACA and IBK were supposedly sophisticated investors (the "big boy" defense).

That ignores the fact that the securities were being prepared for the market, and could be resold by any of the parties involved at any time. Goldman therefore had a legal obligation, in the prospectus, to point out material facts that may influence a further buyer, not just the original parties.

I would've asked Goldman, in the congressional hearings, how many times they had approached a CDO portfolio manager with a preselected basket of securities. Normally, that is the job of the CDO portfolio manager. I'll bet that they didn't do too many of them that way. THAT is a material fact that made this deal different from most others.

I also wish that Carol Loomis had asked Buffett what he thought about whether synthetic CDO's ought be allowed at all. I was thinking about the difference between the municipal bond deal that Buffett and Jain did, and his characterization of Lehman Brothers as a "carny". At least in this case, the carny was involved in an economic transaction with a societal function-- making municipal bonds issued by government entities more salable by attaching the insurance of the name of Berkshire Hathaway. That allows the municipalities to issue securities at a lower cost the taxpayers to build schools, roads and the like.

Contrast that with Goldman -- they dreamed up a deal that used existing securities and credit default swaps to allow one client to bet against another. No new securities were created, no money was made available for investment in either public or private entities. It was a gamble, pure and simple. And, whether it was legal or not, they conspired with one side and hid information from the other side.

So who's the carny?

JC said...

Brian - There was absolutely no fiduciary relationship between Goldman and any entity that participated in this transaction.

Brian said...

I never said they had a fiduciary duty. I said "Goldman therefore had a legal obligation, in the prospectus, to point out material facts that may influence a further buyer, not just the original parties."

The court will end up deciding if Paulson's role in the portfolio selection, and the frequency of Goldman's allowing third parties to preselect (in advance of the CDO Manager being hired) constituted a material fact. I suspect they will.

DaveinHackensack said...

Even Buffett's official biographer thinks Berkshire's annual meetings have jumped the shark. Time to move on.