By virtue of alphabetic superiority, Carol Loomis asked the first question of the meeting, and it pertained to the SEC's recent complaint against Goldman Sachs.  Every year the Berkshire meeting begins with a movie that is a kind of Berkshire collage, featuring unpaid cameos by famous people from all walks of life.  For instance, there was a Desperate Housewives skit this year that featured the stars of that show.  Loomis pointe out that every year the movie includes a clip from a 1991 Congressional hearing into Salomon Brothers (which Buffett was temporarily leading in the wake of a crisis) in which Buffett states that he admonished Salomon employees that if they "lose money...I will be understanding; lose one shred of our reputation and I will be ruthless".  Given that, and the fact that Goldman's reputation clearly has been tarnished, what advice would Buffett give Goldman management?

The paraphrased, summarized response:

The nature of the transaction has been generally misreported.  There were four losers in the Abacus transaction, and Buffett focused on two of them.  Goldman Sachs was an unintentional loser.  The main loser in terms of cash was ABN-AMRO.  They lost money because they guaranteed the credit of ACA - they fronted the transaction.  Berkshire does this alot, and lost money in the 70s in a case where they ran into dishonest people.  ABN guaranteed $900m of ACA at a price of $1.6m.  It's hard for Buffett to be sympathetic because ABN-AMRO made a dumb deal.

ACA was a bond insurer.  They started out as municipal bond insurer, but margins got squeezed in that space.  Instead of sticking to their knitting, they moved outside their realm of understanding.  As Mae West once stated, they started out "like Snow White, but drifted".  Not long ago, Berkshire entered the business of muni bond insurance, but always stayed away from things they didn't understand.

Buffett then went into an example of a portfolio of state bonds that Berkshire insured.  He showed a chart of the states involved.  Berkshire was paid $160m to insure $8.25b for ten years.  The deal was presented to them by Lehman Brothers.  Berkshire did not select the bonds...more specifically they did not "dream up this list".  In fact, Lehman Brothers did.  Buffett and his chief insurance guru Ajit Jain analyzed them and proposed the $160m price.  If any of the bonds defaulted, Berkshire was on the hook to make good on the commitments on behalf of the defaulting state.  They didn't know if the ultimate counterparty was Lehman, and what the counterparty's interest in proposing the trade was.  The counterparty could have owned the bonds and merely wanted some protection, or they could have been betting that there would be defaults.  Berkshire didn't care.  They did what ACA should have done: they evaluated the bonds and determined the proper premium.  ACA initially agreed to 50 bonds of 120 that were presented to them.  Through additional negotiation, they agreed to insure 30 more.  In the Berkshire/Lehman case, it was totally Lehman's list - they didn't throw any out.  It was Berkshire's problem to determine creditworthiness.  If they lose money, they're not going after the counterparty due to superior knowledge or anything.  The fact that John Paulson apparently selected specific bonds and asked Goldman to propose the deal (and probably knew more about those bonds) is irrelevant.

The central point of the SEC's complaint seems to be that Paulson had superior knowledge of the overall deal, and Goldman worked with him to structure it and sell it to counterparties, and the counterparties may or may not have known about Paulson's involvement.  The bonds underlying the deal blew up, and the counterparties lost a lot of money while Paulson got rich.

When Warren asked Charlie about his view on the matter, he pointed out that the SEC commissioners were split 3-2 on whether or not to sue, and it's very unusual to take action of this magnitude without a unanimous vote.  He seemed to feel that was unfortunate, and said he would have voted with the minority.

My view

I view this transaction from two angles, and I think it is helpful to have a tiny bit of background on one of the legal issues in question.  This point is central to my business, and I view it as the point on which the whole Goldman transaction turns.  It speaks to the fiduciary duty that Goldman held, in this case.  There is a significant difference between brokers and advisors, and Goldman was a broker in this case.

In layman's terms, I view a broker as being similar to a car salesman who sells cars "As Is - No Warranty".  The buyer in this case has the responsibility to evaluate the vehicle and determine if it is worthy of the price being asked.  The seller undoubtedly has more knowledge of the car than the buyer, and that gap must be bridged to make the deal worthwhile.  If the buyer doesn't have the requisite knowledge to evaluate the car, a mechanic should be hired to provide a recommendation.

An advisor, on the other hand, has a legal, fiduciary duty to act in the best interests of his client.  The advisor would be more like the mechanic.  If he advises the buyer that the car is in great shape, and the car breaks down three days after being purchased, they buyer has a legitimate complaint with the mechanic.

Given that background, the moment I heard about the SEC suit I was skeptical that there was a legitimate legal case there, and I remain skeptical.  To the general public, it likely sounds like Goldman hoodwinked their customer.  To Warren Buffett and to others that are more familiar with these types of transactions, I think it sounds like ACA, ABN-AMRO and others who ended up on the short end of this deal just didn't do their homework.

That's the legal view.  It is now sounding like Goldman Sachs is discussing a settlement, and I think that's unfortunate from the standpoint of proper administration of our legal process, but it's probably a smart move for them.

The ethical angle is far less clear to me.  A follow on to the initial question asked about Buffett's thoughts on the impact to Goldman's reputation.  He feels that the allegation and related press alone cause Goldman to hurt and it hurts morale, but he doesn't really see it as a loss of reputation.  He does believe that the approach now should be to "get it right, get it fast, get it out, get it over."  Standard reputation management in a crisis.  Charlie, on the other hand, added that the standard should be higher than what's legal and convenient.  He feels they shouldn't have dealt with "scuzzy securities", and that plenty has been wrong with Wall Street.  The bottom line is that Berkshire has had a 44 year relationship with Goldman Sachs, and they have bought more companies through them than anybody else.  They trade with them, and Goldman doesn't tell them what their position is, i.e. shorting or trading from own inventory.  They act in a non-fiduciary capacity when they trade with Berkshire.

<soapbox>I think there are a lot of distasteful things that take place on Wall Street every day.  However, the SEC is making a show of attacking Goldman Sachs on points of dubious legality when they were trading with institutions that are very sophisticated investors.  At the same time, individual investors are being duped on a daily basis because they are not even aware that a distinction exists between brokers and advisors, and that their "advisor" is actually acting in his or her own best interest.  I'd like to see the SEC let the professionals make their own mistakes, and spend a bit more energy on protecting the rights of individual investors from people like Bernie Madoff as well as the Wall Street firms.</soapbox>

This past week has been pretty busy for me, as I attended the Berkshire Hathaway annual meeting last weekend, and the Wesco annual meeting on Wednesday.  Wesco is run by Warren Buffett's partner Charlie Munger.  Whereas the Berkshire meeting has the atmosphere of a very popular circus, the Wesco meeting features about 1% of the attendees of the Berkshire meeting, and it allows for more unfiltered Mungerisms, which makes it well worth the effort.

Last year I took voluminous notes at the Berkshire meeting, and barely shared any of them.  The process felt daunting and I was very busy.  That's no different this year, but I think there is a lot of value in what was communicated, and that value is definitely worth sharing.  Nonetheless, I plan to do this in digestible pieces, which should make it more readable and more feasible for me.

One point about the logistics of the meeting:  beginning last year, the Q&A process alternated between those being asked by three journalists, and those being asked by members of the audience.  The journalists were Carol Loomis, Becky Quick and Andrew Ross Sorkin.  They each receive thousands of questions from the investing public, and whittle them down into broad themes and form specific questions accordingly.  I took notes on most questions asked by the journalists, but not on all questions asked by the audience.  Some just didn't hold much interest for me.  Other questions didn't strike me as worthy of particulary insightful responses.  Consequently, my sharing will be selective.

First up (next post):  Warren Buffet's view of the recent troubles at Goldman Sachs.

On Saturday Warren Buffett released the Berkshire Hathaway annual report for 2009, accompanied by his customary shareholder letter.  It won’t hit mailboxes in printed form for a little while, but undoubtedly many people will read it online long before it gets to them.  I thought I’d dedicate a post or two to sharing what I see are some key points emanating from the brain of Buffett via his shareholder letter.  I’ve always felt this was an entertaining and informative read, and this year has not been a disappointment.  You might wonder why you should care what Warren Buffett thinks.  Like anybody else, he has made some good calls and has been off base about some things.  (I should point out that when he's wrong it's usually a matter of timing, and it happens much more infrequently than when he's right).  Regardless, through the companies he owns and the people he knows, he has an almost unequaled perspective on the American economy.  He also has a very rational view of the world, unencumbered by politics, and to a large degree, personal political ideology.  The engine of Berkshire is the insurance business.  They own banks and other financial services companies, as well as having major exposure to residential real estate.  The roots are based in basic, industrial companies.  In other words, Berkshire is directly exposed to pretty much all of the areas of the economy that have caused great concern over the past couple of years.  Although Buffett may be hands-off to a large degree in the operations of most of his businesses, he knows precisely what is going on in all of them.  The last obvious point in favor of lending credence to his views is simply that his investing performance has been unparalleled.  

One thing about the letter that is clear right off the bat is the fact that he felt the need to restate the basic tenets of owning Berkshire Hathaway.  The Berkshire Owner’s Manual is posted online on an ongoing basis.  Recently, however, Berkshire’s B shares have split 50 for 1 to facilitate the purchase of Burlington Northern, and there has been a huge influx of new shareholders.  For that reason, Buffett seems to give more attention than in most years to reiterating the overall philosophy of Berkshire Hathaway.   While it’s true that he reinforces basic concepts every year – and really every chance he gets -  this remains valuable information whether you’ve owned shares for several decades, or you are merely interested in learning from a great investor.

Perhaps the most universally interesting topic Buffett addressed was the state of residential real estate.  He may not typically be associated with this industry.  However, as he points out in the letter, Berkshire-owned MidAmerican Energy in turn owns HomeServices of America.  HomeServcies owns a broad collection of regional realty firms that combined make them the second largest real estate brokerage firm in the US.  Additionally, their website specifies that they are the “largest brokerage-owned settlement services (mortgage, title, escrow and insurance) provider in the United States.”  Berkshire also owns Clayton Homes, which has become the largest maker of modular and manufactured homes in the US.  This is all a long-winded way of saying that Buffett has a pretty good vantage point from which to view the problems and opportunities facing residential real estate.

First, some numbers.  Total industry output of manufactured homes has dropped from 382,000 in 1999 to 60,000 in 2009.  That has led to the bankruptcy of 1999’s top three manufacturers.  More generally, housing starts in the US have dropped to a fifty year low, at 554,000. (For some context on the trend of housing starts, see the chart at the bottom of this post.)

At last year’s annual meeting, Buffett talked at some length about the supply and demand dynamics in real estate, and how prices will start to pick up again when we work off the excess inventory that existed then in the system.  Typical, rational view of things, and of course he had the numbers at the tip of his tongue. 

The big news coming out of this discussion?  Warren Buffett believes that within the next “year or so” our housing problems should be largely behind us.  Of course, housing is overwhelmingly a local phenomenon, and there will be regions that continue to feel the effects of overbuilding well beyond 2011.  Furthermore, the upper end of the spectrum in many areas may still be years away from real recovery.  For instance, I recently saw data for the Phoenix area that indicated that inventory for homes under $400,000 was actually approaching neutral, meaning that it didn’t particularly favor buyers or sellers.  However, above $3m (I think…may have been $2m) there was enough inventory to serve buyers for over five years!  Note:  don’t hang your hat on these numbers as they are approximate and a couple of months old.  The point remains, though.

We may still be in for some bumps, but I suspect it’s comforting for most people to hear one of the most rational players in American business state that there’s light at the end of the tunnel.

Housing Start Data, courtesy of the US Census Bureau