The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

The much-anticipated annual letter to Berkshire Hathaway shareholders of its Chairman Warren Buffett has long been valued for its business insights and occasionally humorous tone. The 2009 version, which was released on Saturday February 27, 2010, and which can be accessed here, is no exception, though the expanding size of Berkshire’s business portfolio has reduced Buffett’s discussion of many company operations to just a few sentences and left relatively little space for his usual commentary.

 

Buffett does manage to work in some choice observations about the responsibilities of financial institutions’ senior officials for their companies’ collapses, and also about boards’ responsibilities in the M&A context.

 

For many readers, the 2009 version may be noteworthy for the things it does not discuss. For example, the 79-year old Buffett has nothing to say about leadership succession planning at the company (although the February 27, 2010 Wall Street Journal does fill the gap somewhat with an interesting article, here, about possible Buffett successor David Sokol, the Chairman of MidAmerican Energy)

 

Buffett also has nothing to say about recent events of keen interest to Berkshire’s shareholders, including the company’s addition to the S&P 500 and its loss of its triple-A financial rating (owing to the company’s deployment of cash for its largest-ever acquisition of Burlington Northern Santa Fe).

 

But despite the omissions, there is still much of interest in this year’s letter. Full disclosure: I hold BRK.B shares, although not nearly as many as I wish I did. (Actually, I do own more shares than I used to, due to the January 2010 50-for-1 split of the B shares.)

 

Buffett on Boards of Directors

For readers of this blog, the most interesting comments in this year’s letter are Buffett’s remarks about senior management of the financial institutions at the center of the global financial crisis. Buffett prefaces his comments by stating that he would never "delegate risk control," going on to contend that "in my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control."

 

Buffett not only suggests that corporate leaders should have full responsibility, but that there should be liability consequences for failure. Buffett says that if the CEO "fails" at risk control, "with the government thereupon required to step in with funds or guarantees," the "financial consequences for him and his board should be severe." Buffett notes that it has "not been shareholders who have botched the operations of some of our country’s largest financial institutions," yet they have had to "bear the burden" caused by the management errors. Despite shareholder losses, "the CEOs and directors of the failed companies … have largely been unscathed."

 

Buffett proposes that "the behavior of the CEOs and the directors needs to be changed," and they way to do that he suggests is to ensure that if "institutions and the country are harmed by their recklessness," then "they should pay a heavy price – one not reimbursable by the companies they’ve damaged or by insurance." Senior managers have long enjoyed "oversized financial carrots," now their employment arrangements should now include "meaningful sticks."

 

Buffett’s grumpy ruminations about board behavior don’t stop there; later in his letter, he returns to the boardroom context to discuss board functioning in the M&A context. He notes, based on his "more than fifty years of board membership," that directors often are "instructed" by "high-priced investment bankers (are there any other kind?)" on the value of a proposed acquisition target. But "never" has he heard investment bankers "or management!" discuss the "true value of what is being given" for the acquisition when company stock is being used to finance the acquisition.

 

Buffett proposes, as the only way to get "a rational and balanced discussion," that directors hire a "second advisor to make the case against the proposed acquisition," with the advisor’s fee "contingent on the deal not going through." He concludes with an observation about the way deal advisors typically function by the aphorism "Don’t ask the barber whether you need a haircut."

 

 

Buffett on Berkshire’s Investments

Overall, Buffett’s letter is upbeat, as might be expected in a year in which his company’s net worth rose $21.8 billion and income rose 61 percent to $8.06 billion. (This after the company reported in 2008 its worst results ever, due to the effects of the global financial crisis.)

 

Buffett is particularly chipper in talking about the performance of the company’s investments. He notes that the company has "put a lot of money to work during the chaos of the last two years," adding that its been an ideal period for investors" because "a climate of fear is their best friend."

 

The tale of Berkshire’s recent cash deployment is truly remarkable. The company entered 2008 with $44.3 billion in cash and cash equivalents, and during 2008 and 2009 the company retained an additional $17 billion in earnings. Nevertheless, by the end of 2009, the company’s cash pile was "down" to $30.6 billion (with $8 billion of that earmarked for the Burlington Northern acquisition) – implying a net cash outflow of $47.6 billion, or as much as $55.6 billion if the Burlington Northern obligation is taken into account.

 

Where has the cash gone? Well, in addition to the massive Burlington Northern deal and other items, the company invested an absolutely astonishing $22.1 billion in non-traded securities of just five companies: Dow Chemical, General Electric, Goldman Sachs, Swiss Re and Wrigley. Under the heading "that’s why he’s Buffett and you're not," it should be noted that these investments (which cost $22.1 billion) have a carrying value of $26 billion and also deliver an aggregate $2.1 billion annually in dividends and interest (or roughly 10% of cost annually, meaning the investments will pay for themselves in about 7.2 years).

 

Moreover, these massive purchases are far from the only investment successes on Buffett’s scorecard. Berkshire’s $232 million investment in 2008 in Chinese battery maker BYD Company is now worth $1.9 billion. Buffett also accumulated corporate and municipal bonds in 2009, which he called "ridiculously cheap." But, he wrote "I should have done far more. Big opportunities come infrequently. When it's raining gold, reach for a bucket, not a thimble."

 

Not all of Buffett’s financial moves have been funded out of cash; the company also sold some investments, including in particular its holdings in Conoco Phillips, Proctor & Gamble and Moody’s. Each of these investment sales is interesting in its own way.

 

In his 2008 letter, Buffett cited his mid-2008 purchase of ConocoPhillips as one the "dumb things" he had done during the year, referring specifically to the purchase as a "major mistake of commission" because he bought the shares at their peak. Berkshire’s P&G holdings were the result of P&G’s acquisition of Gillette, which had been a major Berkshire holding for many years prior to that. Buffett seemingly was less interested in holding the shares of the more diversified company.

 

The sale of the Moody’s shares is perhaps the most interesting move, as the company’s Moody’s position had been a prominent part of its portfolio for many years. Moody’s share price has plunged during the last couple of years as a result of controversies surrounding the company’s ratings of subprime-related investments. Buffett has plenty to say in his 2008 letter about the excesses that cause the subprime meltdown, but even then he omitted any mention of Moody’s. Perhaps his sale of the company’s shares, even if accomplished without comment or observation, is the most eloquent statement he could make. (As an aside, in April 2009, Moody’s downgraded Berkshire from its highest investment rating.)

 

Buffett on Berkshire’s Balance Sheet

Though Buffett says nothing about the company’s loss of its triple-A financial rating, he has a great deal to say (perhaps defensively?) about the company’s financial strength. He emphasizes that "we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity."

 

He goes on to comment, somewhat triumphantly, that "when the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity to the system, not a supplicant." adding that "at the very peak of the crisis we poured $15.5 billion into a business world that could otherwise look only to the federal government for help."

 

Buffett on Berkshire Shareholders

As I have previously noted (here) about Buffett’s essays to Berkshire shareholders, one of the not so subtle goals of his missives is to try to ensure that the company has the right kind of shareholder – that is, investors willing to take a long-term view and patient enough to await long-term results. Due to the Burlington Northern acquisition (and the split of the company’s B shares), Berkshire now has many new shareholders, and in his 2009 letter, Buffett is trying to school these new owners on what he hopes for from them

 

Buffett is very explicit that he wants to "build a compatible shareholder population." On that topic, Buffett sounds some themes that will be familiar to regular readers of Buffett’s letters. He warns his new shareholders that "investors who buy and sell on media analyst commentary are not for us." Rather, Buffett wants "partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand."

 

Buffett on Berkshire’s Businesses

Much of the balance of Buffett’s letter is given over to a review of the operating companies’ performances. With a few exceptions (such as his lengthy exegesis of the systemic challenges facing mobile-home manufacturer Clayton Homes), most of his company-specific reviews are quite brief. Indeed, many Berkshire businesses are not even motioned in the letter. As Berkshire has enveloped more and more companies, the kind of meaningful review Buffett claims to want to provide investors has been increasingly more challenging.

 

Readers of this blog undoubtedly will be interested in Buffett’s review of Berkshire’s massive insurance businesses, which continue to perform magnificently, collectively producing over $1.5 billion in 2009 calendar year underwriting profit despite prevailing soft market pricing conditions. This continued underwriting profitability, even if not shared equally by all of Berkshire’s insurance competitors, virtually ensures that the soft market conditions will continue until either pricing collapses to the point where profit is simply no longer possible or some external event intervenes to overwhelm industry profitability.

　

Discussion

Some may find Buffett’s harsh words about CEOs and corporate boards alarming. His suggestion that company officials should be held liable for the harm they have caused, without benefit of indemnity or insurance, will strike fear into the hearts of company officials everywhere. It is particularly noteworthy that his prescription for individual liability is not limited just to CEOs but expressly extends also to members of the company boards.

 

However, a careful reading of suggests that these remarks may represent less of a threat to corporate officialdom that might appear at first blush. For example, it is clear that his remarks refer to officials at companies whose woes have required a government bailout. His suggestion of direct personal liability without benefit of indemnity or insurance is made with reference to misconduct that causes harm both to "institutions and the country." So, before anybody hits the panic button, Buffett is not necessarily suggesting that indemnification and insurance are never appropriate for corporate officials, but perhaps only when the officials’ misconduct has necessitated a government bailout.

 

But just the same, Buffett’s comments that corporate officials (including, apparently members of boards of directors) should not have recourse to insurance undoubtedly will make some board members uneasy – not to mention how uncomfortable it makes those of us who make our living in the D&O insurance industry.

 

Buffett’s plan for building a shareholder base built on owners who buy into Berkshire’s long term philosophy is commendable. However, as Berkshire has grown, this aspiration may be less realistic. Buffett may want partners invested "in a business they themselves understand" but the reality is that Berkshire may have grown beyond the point where the typical investor can fully appreciate and understand its business.

 

The fact is that much of this year’s letter seems a mile wide and an inch deep – indeed, at one point, he simply lists the names of companies, without any further gloss or detail.

 

Buffett’s description of the results of Berkshire’s insurance businesses is a good illustration of the challenge facing Berkshire’s new shareholders. Buffett is lavish in his praise of Ajit Jain and his thirty person operation. Indeed, Buffett adds the humorous aside that if he, Berkshire Vice Chair Charlie Munger and Ajit were in a sinking boat, "and you can save one of us, swim to Ajit."

 

But as for what Ajit’s 30 person team does to produce hundreds of millions of dollars of profit, shareholders are left with cryptic comments like this statement: "During 2009, he negotiated a life insurance contract that could produce $50 billion in premium for us over the next 50 or so years." Seems kind of important, but as for what kind of risks or uncertainties it involves, Buffett has little to say, because he has already moved on to the next topic.

 

The next topic, in fact, is another Berkshire insurance business, Gen Re, which prior to the Burlington Northern acquisition was Buffett’s largest ever acquisition and Berkshire’s largest operating division. Buffett spares only 125 words for Gen Re, 48 of which are actually about Gen Re’s European subsidiary Cologne Re.

 

Buffett also has relatively little to say about Berkshire’s derivatives exposures, other than to defend these complex transactions that cause Berkshire’s reported results to swing by billions from quarter to quarter. I hope that those of us who can recall that Buffett himself called derivative contracts "weapons of financial mass destruction" can be forgiven for feeling less than entirely comfortable with Buffett’s hasty sketch of Berkshire’s derivatives exposure.

　

Buffett says that "Charlie and I avoid businesses whose futures we can’t evaluate." Some of Buffett’s shareholders may wonder how in the world they are supposed to evaluate the future of a company that is entering massive, complex multi-decade financial commitments but whose leadership will be in place for only a few more years. Despite all of Buffett’s earnest attempts to educate Berkshire’s owners, current and prospective investors may simply have to take it on faith – which certainly does shine a harsh spotlight on that unanswered leadership succession issue.

 

But for all of that, the annual letter is not a disappointment. It continues to be worth waiting for. Buffett did manage to work in the zingers about corporate responsibility. And he even slipped in some of his signature humor. My personal favorite in this year’s letter is his remark, made as a demonstration of Prussian mathematician Jacobi’s inversion principles, that if you "sing a country song in reverse … you will quickly recover your car, house and wife." He ends his letter, with its extensive discussion of the Burlington Northern acquisition, with a postscript suggesting that visitors attending the May shareholders meeting should "come by rail."

 

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On February 28, 2009, Berkshire Hathaway released (here) the annual letter of its Chairman Warren Buffett, to the company’s shareholders. Like prior editions, this year’s letter contains homey and often humorous aphorisms and thought-provoking observations both about Berkshire and about the business economy as a whole. But, consistent with the fact that 2008 was Berkshire’s worst year ever, this year’s letter is much denser than prior years’ and -- along with Buffett’s usual tone of self-deprecation – reflects some occasional and uncharacteristic notes of defensiveness. There is at least one rather noteworthy omission from the letter as well. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.)

 

The Letter's Major Themes

The Global Economy: The letter opens with a sober appraisal of the "debilitating spiral" into which the global economy slipped during 2008. Buffett observes that these dire circumstances produced unprecedented governmental action, steps that were "essential" if the "financial system was to avoid total breakdown." But these "massive actions," while necessary, will "almost certainly bring on unwelcome aftereffects," including an "onslaught of inflation."

 

Buffett also expressed his concern that "the economy will be in shambles throughout 2009, and, for that matter, probably well beyond." However, in contrast to this gloomy shorter term view, Buffett’s long view is optimistic. He notes that "our country has faced far worse travails in the past," but that "without fail we’ve overcome them." Buffett asserts that "America’s best days lie ahead."

 

Berkshire’s Investment Performance: But even if the longer term view is bright, the immediate picture isn’t pretty. Berkshire’s 2008 results were its worst ever. On the other hand, the company’s results were considerably better than those of the S&P 500 companies. For example, Berkshire’s book value per share declined by 9.6% in 2008, while the S&P stock index fell 37% last year, including dividends.

 

The overall value of Berkshire’s investment portfolio fell 13.89%, form $90,343 per share to $77,793 per share. Nineteen of top 20 stakes in Berkshire’s U.S. stock portfolio declined last year.

 

Contributing to this investment decline were some "dumb things" Buffett did in managing Berkshire’s investments, including a "major mistake of commission" involving a major acquisition of ConocoPhillips stock when oil prices were near their peak. Buffett comments in the letter that "the terrible timing of my purchase has cost Berkshire several billion dollars." Buffett also noted his poor timing in spending $244 million to invest in two Irish banks that have since declined 89% in value.

 

Berkshire’s Derivatives Portfolio: Nearly a quarter of the shareholders’ letter is given over to Buffett’s defense of Berkshire’s derivatives portfolio. Greater detail regarding the portfolio was not only requested by regulators, but it was perhaps obligatory in any event, in part because of Buffett’s own long standing criticism of derivatives as "financial weapons of mass destruction," but also because of what the derivative investments did to Berkshire’s reported 2008 financial results.

 

The company’s share price has declined over 40% in the past year largely due to concerns about the company’s exposures to derivatives. The company’s fourth quarter net income fell 96 percent to $117 million from $2.95 billion in the prior year’s final quarter. The decline is primarily the result of mark to market losses on long-term derivative investments in Berkshire’s portfolio.

 

But while detailed disclosure of Berkshire’s derivative portfolio may have been mandatory, Buffett seems rather grumpy about it. Indeed, at virtually the same time Buffett lays out the company’s derivative investments, he mutters some rather disparaging remarks about the futility of increased "transparency" requirements for "describing and measuring the risk of a huge and complex portfolio of derivatives."

 

In case some readers might conclude that Berkshire itself has a huge and complex portfolio of derivatives (and, in my view, that is the only conclusion that anyone acquainted with the facts, even as presented by Buffett, reasonably could reach), Buffett strains to try to differentiate Berkshire’s portfolio. Not only were Berkshire’s derivative contracts "mispriced at inception," but also, by contrast to many similar arrangements, Berkshire "always holds the money." Moreover, only "a small percentage of our contracts call for posting of collateral," and even under last year’s chaotic conditions," Berkshire had to post less than 1% of its securities portfolio."

 

So, I guess the message is, don’t be alarmed by those massive, multi-billion dollar "mark to market" write-downs -- everything is fine. My own view is that Buffett was much more persuasive before when he was decrying derivaties as "financial weapons of mass destruction." 

 

The Subprime Debacle: Buffett’s letter also contains a separate homily about the experience of Berkshire’s mobile home subsidiary, Clayton Homes, whose recent performance is, in Buffett’s retelling, a sort of morality tale against which to compare the events that up to the subprime meltdown.

 

Though they are people of "modest incomes and far-from-great credit scores," Clayton’s mobile home buyers have much lower default and foreclosure rates that those of many similar residential borrowers because "they took a mortgage with the intention of paying it off, whatever the course of home prices." The mobile home buyers didn’t "count on making loan payments by refinancing" and they weren’t seduced by "teaser rates."

 

Buffett observes that foreclosures don’t happen because housing prices decline, but because borrowers "can’t pay the monthly payment they agreed to pay." The home purchased "ought to fit the income of the purchaser." And, Buffett adds, homeowners who have "made a meaningful down payment – derived from savings and not from other borrowing – seldom walk away from a primary residence."

 

Buffett concludes with the observation that "putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective." However, keeping them in their homes "should be the ambition."

 

Tax- Exempt Bond Insurance: Buffett also takes considerable pains to describe Berkshire’s move into tax-exempt bond insurance, and how the financial troubles of the traditional monoline bond insurers allowed Berkshire an opportunity to reap outsized premiums for "second-to-pay" insurance (triggered if the primary monoline carrier defaults).

 

Though unabashedly gleeful in describing this opportunity and how it came about, Buffett also gravely notes that it is "far from a sure thing that this insurance ultimately will be profitable for us." He notes that while municipal debt historically has enjoyed an essentially default free record, the future could be far different, and indeed, the very presence of Berkshire insurance could itself trigger a higher rate of defaults. Buffett also notes that defaults could be correlated. In short, insuring tax exempts "has the look today of a dangerous business."

 

Some Interesting Sub-topics

In addition to the major themes, there are also of narrower message salted throughout the letter. Some of these, although barely mentioned, are among the letter’s more interesting details.

 

For example, I was interested to note that as a result of Berkshire’s unsuccessful bid to acquire Constellation Energy, Berkshire not only received a break-up fee of $175 million but also reaped an investment gain on the Constellation shares it did acquire of $ 917 million. I supposed Berkshire could hardly be described under these circumstances as a "disappointed bidder." (The details of the transaction are briefly summarized here.)

 

Buffett also tucks into the letter a brief commentary of how the swing of the risk-tolerance pendulum had resulted in the "U.S. Treasury bond bubble of late 2008," which could be regarded as "almost equally extraordinary" as the "Internet bubble of the late 1990s and the housing bubble of the early 2000s." Buffett predicts that clinging to cash equivalents or government bonds will almost certainly be "a terrible policy of continued too long," if for no other reason that inflation alone will "erode purchasing power."

 

There are also a couple of separate notes in the letter about Berkshire’s apparent growing commitment to green energy. In his description of Berkshire’s utilities businesses, Buffett describes the utilities businesses’ growing wind power output. And in his description of the upcoming Berkshire shareholders’ meeting, he notes that among the exhibits at the meeting will be a "new plug-in car developed by BYD, an amazing Chinese company in which we own a 10% interest."

 

Commentary

While this year’s letter rewards careful reading just as much as prior years’ letters, and though this year’s letter arguably contains even more that customary detail, there are nonetheless some critical omissions.

 

First and foremost, the letter is silent about the criminal fraud convictions during the past year of the former CEO and former CFO of the Berkshire’s largest subsidiary, General Re, for misconduct committed while General Re was a part of the Berkshire group. For details regarding the convictions, refer here and here. (Full disclosure: for several years, I was employed by a General Re subsidiary.)

 

At one level, this omission may be understandable given questions some have asked about Buffett’s own possible involvement in the events at the heart of the prosecution. But given these criminal convictions, the letter’s happy talk about General RE’s 2008 annual results – including Buffett’s euphemistic reference to the fact that the subsidiary’s successor CEO also "stepped down" during the past year, without any reference to the reasons for the successor CEO’s other than purely voluntary departure – rings hollow, or at least lacking in context.

 

There is an ironic contrast between this rather obvious omission and the withering tone Buffett employs later in his letter to describe the June 15, 2003 OFHEO letter and report that "were delivered nine days after the CEO and CFO of Freddie had resigned in disgrace and the COO had been fired." Some might call it hypocritical on the one hand for Buffett to disparage OFHEO’s letter for its failure to mention the Freddie Mac officials’ departures while at the same time himself omitting even to acknowledge the criminal convictions of the two most senior officials of his company’s largest subsidiary.

 

In addition, while Buffett was characteristically direct in acknowledging the mistaken timing of his ConocoPhillips investment, I think it is worth noting that the ConocoPhillips and Irish Bank investments were far from the only recent Berkshire investments that may have been ill-timed.

 

Looking at Berkshire’s largest stock holdings, it appears that many of Berkshire’s most recent investments are faring poorly. In particular, the recent investments in Swiss Re (down 85% the past year), on which Buffett recently doubled down, raises certain questions.

 

For that matter, some of Buffett’s longer term investments have also declined beyond market wide averages, including in particular American Express (down 71% in the past year) and Moody’s (down 53% in the past year).

 

Of course, times are tough throughout the financial arena, and not even Berkshire is immune from the current overwhelming financial downdraft. Among many interesting points Buffett makes in his letter is his observation that 75% of the time during Berkshire’s 44-year history, the S&P 500 has recorded an annual gain, adding that he guesses "a roughly similar percentage of years will be positive in the next 44."

 

We can all, even those who may not own Berkshire shares, hope that Buffett is right about the prospects for future positive results.

 

A Final Note: My review of Alice Schroeder’s recent biography of Buffett, "The Snowball," can be found here.

 

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When asked at the October 7, 2008 presidential debate whom he would appoint as his Treasury Secretary, John McCain commented that "it’s going to have to be someone that inspires trust and confidence." The first specific name McCain mentioned was that of Warren Buffett, someone, as McCain noted, that has "already weighed in and helped stabilize some of the difficulties in the markets."

 

In some ways, it is no surprise that McCain mentioned Buffett (notwithstanding the fact that Buffett has – as McCain duly noted – publicly supported Barrack Obama), given Buffett’s prominence and reputation. And in view of Buffett’s wealth and well-known business approach, it is unsurprising that once again Buffett is in the position to offer financial aid to troubled companies.

 

But while Buffett’s mention as a potential Treasury Secretary in a time of turmoil might now be unsurprising, it is worth reflecting that there is nothing about the way Buffett achieved his wealth, prominence or reputation that was inevitable. The remarkable story of how Buffett achieved this level of respect while he accumulated his vast fortune is compellingly told in Alice Schroeder’s splendid new biography, The Snowball: Warren Buffett and the Business of Life.

 

While numerous prior authors have attempted to detail Buffett’s life, none had the benefit of direct access to Buffett himself, as well as to his blessing to contact his family and friends, as Schroeder did. In addition, because Schroeder spent five years between 2003 and 2008 gathering material and writing her book, she wound up as a percipient witness to many of the critical events of the most recent years of Buffett’s life.

 

What emerges is more literary than a mere business biography. Indeed, prospective readers should probably be forewarned that this book is not devoted to the minute exploration of Buffett’s investment philosophy or his approach to investment decisions. Readers particularly interested in that aspect of Buffett’s story would do better to read Roger Lowenstein’s excellent 1995 Buffet biography, entitled Buffett: The Making of an American Capitalist.

 

Readers who want to understand the development and character of a man who has come to embody trust and integrity at a time when those qualities are sorely lacking (particularly in the financial marketplace) will find Schroeder’s book absorbing and instructive. The power of the book is its deep appreciation of the sweep of Buffett’s life, the role of so many of the key people he befriended along the way, and its respect for the way that events and experiences shaped and changed him.

 

For Buffett devotees such as myself (full disclosure: I own Berkshire Hathaway B shares, although not nearly as many as I wish I did), the book is full of rich anecdote and fascinating detail even with respect to events well told before. For example, the details of Buffett’s childhood have been well-chronicled, but no prior account of his life so thoroughly explores the significance of Buffett’s relationship with his parents, particularly his respect for his stock broker and congressman father and his fear of his tempestuous, unstable mother.

 

As a result of Schroeder’s access, her book also discloses numerous interesting details about Buffett’s early life, such as the fact that the current paragon shoplifted extensively from the Sears near his parents’ home while his father sat in Congress.

 

In an incident full of significance given recent events, Buffett, while a ten-year old on a visit to New York with his father, visited the offices of Goldman Sachs. Who could have foreseen the role he would come to play a half century later at a critical moment in the firm’s existence?

 

And the counterparty on Buffett’s first transaction while a brand new trader at Graham-Newman investment bank -- a complex arbitrage deal involving cocoa beans and cocoa bean futures -- was a shrewd investor named Jay Pritzker, whose family business, Marmon Corporation, Buffett would agree to buy in a multi-billion dollar transaction in late 2007 (refer here).

 

But even more significant than these details is the overarching theme that defines the book. This book is not so much about the way Buffett accumulated wealth as it is the way he accumulated friends and knowledge and insight. The friends enriched his life and contributed each in their own way to Buffett’s remarkable personal story. The roles that Ben Graham and Charlie Munger played have been noted elsewhere but the inside account of how Munger and Buffett met, became friends and began investing together is fully explored in this book. Schroeder’s access allowed her to describe how Buffett met and became friends with Bill Gates, and even more significantly the intellectual and philanthropic interests they share.

 

Schroeder’s emphasis on Buffett’s relationships, combined with her unfettered access and her obvious preoccupation with the topic, leads her to explore Buffett’s complex relationships with the women in his life. The book makes it clear that Buffett might well not have become who he is without the influence in his early adulthood of his late wife, Susie.

 

The book also explores Buffett’s relationships with other women, including his long-time friend Astrid Menks, with whom he lived for nearly 30 years while still married to Susie, and whom he married after Susie’s death; Kay Graham, the publisher of the Washington Post, with whom he had something more than a mere business partnership; and Sharon Osberg, his bridge partner and frequent companion. Undoubtedly due to her privileged status as authorized biographer, Schroeder is very elusive about the exact nature of Buffett’s relationship with these women, as well as Susie’s relationship with her long time friend and tennis coach (to whom Susie left $8 million in a secret and surprising codicil to her will).

 

Schroeder’s exploration of Buffett’s emotional life is perhaps at its most perceptive pitch in her analysis of the events surrounding the near collapse of Solomon Brothers in 1991. In the usual retelling of the tale, Buffett is portrayed as the gallant knight riding to the rescue, saving the company by the sheer strength of his integrity. Schroeder makes it clear that these events were for Buffett horrible and extremely challenging.

 

Buffett also found these events distressing, but not because he could have lost an enormous amount of money if the company failed. Rather, the events at Solomon filled him with dread and anxiety because the events could have cost him something even more precious – his reputation. In a particularly noteworthy detail about the episode, and one that says a great deal both about Buffett and about the culture of Wall Street, the book recounts that the senior managers at Solomon, whose jobs Buffett saved, sneered that "all he cares about is his reputation."

 

Notwithstanding her privileged access, Schroeder does not by any means avoid identifying Buffett’s shortcomings. Indeed, he comes across in many ways as a stunted person, someone whose world view is so limited that no matter how important the occasion or the requirements of decorum, he cannot bring himself to eat anything but a hamburger and French fries. His perspective is so narrow that he never noticed that the walls of the guest bedroom at Kay Graham’s house, where he stayed many times, were lined with original Picassos. He also comes off as almost childlike in his extremely squeamish inability to tolerate any discussion of someone’s medical issues or other topics he found uncomfortable.

 

Buffett was forced to confront many of these issues during Susie’s final illness and death. Because Schroeder was present during many of the events surrounding Susie’s death, her description of these events take on a particularly novelistic quality. Her recounting of the events is interwoven with Buffett’s own description to Schroeder of his thoughts and reactions, feelings and emotions. The depiction of Susie’s death is moving and serves as a reminder that even great wealth is no protection against the most basic of human susceptibilities. Although we are reading about these events because of who Buffett is, it is their universal character that gives the description its power and depth.

 

It is through the characteristics such as this that the book gains its ultimate insight, which is that Buffett was not born as "Buffett" nor did he one day simply become "Buffett." Rather, Buffett has become who he is as his life has evolved, and he has been becoming Buffett and has continued to become Buffett all along the way. Consistent with the book’s metaphorical title, Buffett has accumulated many things, not just wealth, but friends, and even wisdom and insight.

 

While she admittedly had a worthy subject to begin with, Schroder has managed to do something remarkable. She has managed to take the story of one man’s accrual of enormous wealth, a feat that might seem base or even vulgar, and turned it into a tale worth pondering. Schroder’s book succeeds because she understands that what makes Buffett fundamentally interesting is not the mere fact of his wealth alone, but how he conducted himself both while he became wealthy and even after (perhaps especially after) his fortune was assured.

 

That said, this is not a perfect book. For one thing, at 838 pages (not counting endnotes and the index), it is way too long, arguably by as much as one third. By way of illustration, someone should have stopped Schroeder from reporting that Astrid had a pedicure at Canyon Ranch while Susie was recovering from surgery. And the book would have been improved without such details as the lengthy description of Susie’s visit to Bono’s Mediterranean villa. There are many other unnecessary details of the same kind.

 

I also think it is a flaw, and a surprising one too, that Schroeder does not fully discuss the history of Buffett’s investment in General Reinsurance Corporation. (Full disclosure: for several years, I was employed by a Gen Re subsidiary). Give Schroeder’s background as a PaineWebber securities analyst for the insurance industry, I expected her to have much more to say about the Gen Re transaction and the way it turned out, especially in light of the fact that it was and still is Buffett’s largest acquisition ever. In the book’s "Afterword" Schroeder explains that because of certain continuing legal issues involving Berkshire, and the possibility that she might be a witness, she does not feel entirely free to comment. But while this explanation makes the paucity of discussion of Gen Re understandable, the limited treatment of the topic does diminish the book.

 

Notwithstanding its flaws, I still enthusiastically recommend the book. The timing of the book’s arrival, coincident with all of the astonishing recent events in the financial markets, dramatically underscores the wisdom of so many of Buffett’s recurring messages. He may or may not be the right choice to be Treasury Secretary, but if his health lasts, he undoubtedly will play a significant role in many of the events to come as the financial crisis continues to unfold.

 

Regardless of how events play out, Buffett’s humor, wisdom and insight will provide useful guidance for years to come, and not just for investors, but for anyone who aspires to reach a goal and to do so with their integrity intact.

 

A Literary Afterword: The narrative sweep of Schroeder’s book and the inclusion of so many family, friends and personal details gives the book the air of a family saga, and in many ways the book has the makings of a great novel. This characteristic of the book brought to mind another great book about the conflicts of life and business within one family, Thomas Mann’s first novel, Buddenbrooks.

 

Though Buddenbrooks is set in a much different time and place (19^th century Germany) and though it is much a much darker, fatalistic and negative book (its subtitle is "The Decline of a Family"), it nevertheless represents a sweeping retelling of the fortunes of one family and how business affect the lives of four generations.

 

Some might consider it more than a stretch to invoke Buddenbrooks in connection with Schroeder’s biography of Buffett. I certainly do not mean to suggest any comparison between Schroeder and Thomas Mann. But I do think the two books share a common goal. That is, both books aspire to draw moral lessons from the interaction of business and life within the context of a single family. The moral conclusions may differ significantly, but both books offer insight into the ways life can be lived, on the practical level where the business of life actually is conducted.

 

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According to various news sources (here), Kansas Bankers Surety (KBS, about which refer here), a unit of Berkshire Hathaway, is exiting the business of privately insuring bank deposits beyond the $100,000 limit of the Federal Deposit Insurance Corporation. The September 10, 2008 Wall Street Journal reported (here) that the company is notifying about 1,500 banks in more than 30 states that it will no longer offer bank deposit guaranty bonds.

 

The part of this story that interests me (and, I am guessing, most other people, too) is the Journal’s statement that, according to sources, the order to stop insuring bank deposits came directly from Warren Buffett himself, although a spokesman for the company declined to comment on the report.

 

The Journal article also shed a little bit of light on what might have precipitated the decision. The article reports that KBS insured some deposits of Columbian Bank & Trust Company of Topeka, Kansas which failed on August 19, 2008 (about which refer here), which at the time of its failure had 610 accounts representing approximately $46 million potentially exceeding government insurance limits.

 

It is unclear from news reports what KBS’s exposure is in connection with the Columbian Bank failure. However, Columbian Bank is one of eleven banks to have failed already this year, and concerns about further failures loom. As the Journal article stated, the decision for KBS to withdraw from bank deposit guaranty bonds is "an indicator of how many in the industry are worried about future bank failures."

 

The prospect of future losses could have been a precipitating factor in KBS’s pullback. But I am guessing that Buffett himself needed little persuading to exit this business. He has a long-standing and very public antipathy for the banking business. As he wrote in one of his annual letters to Berkshire’s shareholders (here):

 

The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

 

Some readers may wonder about these comments in light of Berkshire’s substantial investment in Wells Fargo. Specifically, as of December 31, 2007, Berkshire owned 303,407,068 Wells Fargo shares, representing 9.2% of the shares outstanding, at today’s price worth more than $10 billion. Buffett commented on his willingness to invest in Wells Fargo at the time he made his first significant investment in the company, notwithstanding his general antipathy for banks, citing the quality of Wells Fargo's management and its culture.

 

However, at the same time Buffett lauded Wells Fargo’s virtues, he also acknowledged its vulnerabilities:

 

Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.

 

Readers may be interested to know when Buffett wrote these statements. Both Buffett’s remarks about the lemming-like qualities of banking managers and the potential problems of systemic risk and overbuilding on the West Coast appeared in Buffett’s 1990 letter to Berkshire shareholders. Reading his 1990 remarks some eighteen years later does suggest that history seems destined to repeat, at least when it comes to banking. From the 1990 shareholders’ letter is also clear that part of the reason Buffett was willing to invest in Wells Fargo then was that, due to terrible banking results at the time, bank stocks were beaten down and Wells Fargo was a relative bargain.

 

There have been numerous reports that we are now facting the worst set of conditions for the banking industry since that prior period. Although Buffett was then able to make a favorable investment in Wells Fargo, he undoubtedly recalls what happened to others in the banking industry in the late 80’s and early 90’s. The current conditions are similar to those from which Buffett profited in the past. He undoubtedly has aspirations of repeating that performance this time around, but at the same time he has no interest in footing the bill for depositors’ losses in excess of FDIC insurance.

 

If Buffett thinks this movie looks like a remake of old familiar classic, his actions suggest that he is pretty sure he know what is going to happen in the next scene.

 

From the Archives: Buffett is not the only one who memory runs back to the earlier era of failed banks. Many of us oldsters in the D&O business earned our spurs during the S&L crisis and era of failed banks in the early 80s and 90s. If we are indeed headed into another period of significant bank failures, many of the themes from that earlier time may again be relevant, including some venerable D&O insurance coverage issues, as I noted on a recent post, here.

 

Back to the Future: Comparisons back to the earlier era of failed banks seems to be the order of the day. According to a September 11, 2008 press release (here) from Navigant Consulting, the subprime-related litigation filed in federal court in the last 18 months already exceeds the amount of litigation filed in the S&L crisis.

 

The press release states "the number of subprime-related cases filed in federal courts through the second quarter of 2008 has topped the 559 savings-and-loan (S&L) lawsuits of the early 1990s, until now viewed by many as the high-water mark in terms of litigation fallout from a major financial crisis."

 

The release specifically cites the "rising tide of bank failures" as one potential source from which future litigation could emerge.

 

The Navigant data is interesting, but it would be even more helpful if the company had specified how it collected its data and what it was "counting" as subprime litigation. I know from my own efforts to track the subprime securities litigation that deciding what to count and what to exclude is an extremely challenging task. It would enhance the Navigant reports if the company were to provide a little more specificity about exactly what the company’s "count" actually represents.

 

Special thanks to the several readers who sent me links about the Navigant report.

 

The Hits Just Keep on Coming: In my prior post (here) commenting on the government takeover of and litigation involving Fannie Mae, I noted that the company’s huge loss of market capitalization would translate to significant losses throughout the marketplace and that in the weeks and months ahead we would find out where those losses landed. Along those lines, Progressive Corp. today announced (here) a monthly loss for August 2008 of over $135 million, based on large part on the write-down of the company’s holdings in Fannie Mae and Freddie Mac securities.

 

The company reported that during August, its holdings of Fannie and Freddie preferred stock declined $271.4 million and its holdings of the two companies’ common stock declined $6.8 million. The company also reported that following the government’s recent takeover, its holdings in Fannie and Freddie preferred stock declined an additional $171.3 million, which loss will be reported in the company’s September monthly results.

 

For those keeping score at home, that means that the value of Progressive’s holdings in Fannie and Freddie’s preferred securities declined a total $442.7 million in August and September. Even for a company the size of Progressive (the company had YE 2007 assets of nearly $19 billion), that is significant.

 

Progressive is far from the only company that will be reporting these kinds of results in the weeks and months ahead. Indeed, and to bring this blog post full circle, I note in that regard that a September 11, 2008 CFO.com article entitled "Fannie-Freddie Bailout  Losses Hit Banks" (here)  reports that a number of banks have issued warnings about the hits they must take to their balance sheet because of Fannie and Freddie's collapse.

 

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In May 2003, I was fortunate enough to to attend the Berkshire Hathaway annual meeting in Omaha, Nebraska. (Full disclosure: I attended the meeting because I was then and remain now a Berkshire shareholder.) While at the meeting I struck up a conversation with some other attendees, who turned out to be a group of doctors who had attended medical school together, and who now invest together, and who every year have a reunion of sorts at the Berkshire annual meeting.

There are many people like these investing docs who hang on Buffett’s every word, perhaps hoping to replicate in some small way Buffett’s phenomenal investing success. The good news is that it isn’t necessary to go to Omaha to get Buffett’s own words about his approach to investing and business, as all of his Berkshire shareholders’ letters from 1977 to 2007 can be found on the Berkshire website, here.

But while the shareholder letters are available online, they are presented chronologically and are not indexed. There is not even a search function on the website, so other than going through a lot of words written over a lot of years, it is very difficult to find what Buffett has written about, say, zero coupon bonds, and difficult to see how his views on any given topic have changed over the years.

The great news for Buffett devotees is that there is a terrific alternative to laboring through 30 years' worth of Buffett’s letters to Berkshire shareholders. George Washington University Law Professor Lawrence Cunningham has read through all of them for us, and has distilled 30 years’ worth of Buffett’s commentary into a thematically arranged, absolutely wonderful book entitled “The Essays of Warren Buffett: Lessons from Corporate America,” which was recently released in a second edition (here). Professor Cunningham has added a brief introductory essay and afterword, but otherwise the book consists of the essence of Buffett. (It does also include an excerpt from one of Berkshire Vice Chairman Charlie Munger’s Letter to Wes.co shareholders and an amusing parody written by Buffett’s mentor, Ben Graham.)

Cunningham has done a masterful job distilling Buffett’s writings and organizing them according to topic. This arrangement not only facilitates a quick reference to Buffett’s comments on any given topic, but it also provides insight into how Buffett’s views on the topic may have evolved over time.

One thing that clearly emerges from a sustained reading of Buffett’s writing is that he is not only interested in developing the right investments and the right assets, he also wants to have the right sort of owner. Indeed, the reason Buffett has written the letters over the years is to develop and maintain “rational owners”; in the 1988 shareholders' letter, Buffett makes this explicit when he says that “all of our policies and our communications are designed to attract the business-oriented long-term owner and to filter out possible buyers whose focus is short-term and market-oriented.” From his essays about stock splits and dividends, it is also clear that the reason Berkshire has never split its shares and does not pay dividends is because of Berkshire wants to “avoid policies that attract buyers with a short-term focus on our stock price.” He wants investors focused on business values, not the company’s short-term share prices, and while a stock split or dividend might increase trading in Berkshire shares, “a hyperactive stock market is the pickpocket of enterprise.”

Buffett’s writings about the kind of owners he wants also dovetails with his extensive writings about the kind of managers owners should want. He is particularly concerned about the widespread practice of announcing earnings targets, noting the “many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings target they had announced.’ He also says that investors should

beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they will are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.

He adds that “managers that always promise to ‘make the numbers’ will at some point be tempted to make up the numbers.”

This thematic arrangement of Buffett’s writings facilitates insight into the many ways his past experience unquestionably continues to inform his decision making. For example, we might well wonder about Buffett’s view on the current subprime crisis, but when you read his commentary from the late 80s about junk bonds and the Wall Street wizards who created them, you don’t have to wonder very much about what he might think about, say, CDOs backed by subprime mortgages. In his 1990 letter, Buffett wrote about junk bonds that “as usual, the Street’s enthusiasm for an idea was proportional not it its merit, but rather to the revenue it would produce.” Buffett also commented:

In the final chapter of The Intelligent Investor Ben Graham [wrote]:"Confronted with a challenge to distill the secret of sound investment into three words, we venture a motto, Margin of Safety.” Forty-Two years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses.

Buffett went on to write later:

The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failure we described last year when discussing the “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so.

Buffett’s prescience on the problems with derivates has already been the matter of commentary on this blog here.

Anyone who needs persuasion that Buffett truly is a financial master who has the added gift to be able to explain complicated things simply should review the segments of the book discussing zero coupon bonds and the difference between accounting goodwill and economic goodwill.

In addition to Buffett's business wisdom and the clarity of his prose style, the other thing that comes through in these essays is how funny Buffett is, and in that respect Cunningham is to be complimented for managing to capture within a volume devoted to Buffett’s business writings the basic humorousness of the shareholder letters. I’m sure everyone has their favorite Buffett humor stories, but mine include the story told in the  1986 letter about the tailor who went to see the Pope, whose friends asked him what the Pope is like. Buffett writes that “our hero wasted no words: ‘He’s a forty-four medium.’” Another favorite that also makes it into this collection is the story about the man who asked his vet what to do for his horse that limped sometimes but seemed fine at other times. Buffett states that “the vet’s reply was pointed: ‘No problem – when he’s walking fine, sell him.’”

Cunningham’s book also captures my own personal favorite, from the 1985 letter. I have actually quoted this story previously on this blog, but I like it so much, I am reproducing it again here:

An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence”, said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”

In any compendium, there are necessarily going to be some omissions, and while Cunningham’s inclusions are comprehensive and the overall product deserving of praise, I think the volume would be even more complete were it to include selections from Buffett’s writing over the years about insurance. The insurance business has been the segment on which Buffett has concentrated the most, and his reasons for his focus on this industry convey a lot about his approach to investing and his understanding of how business cycles work. In particular, Buffett’s many comments about “float” and the insurance “cycle” convey a lot about what his overall approach to investing and business. Greater inclusion of his insurance writings would also provide greater context for Buffett’s comments about September 9/11, which is included in this volume.

This volume also excludes Buffett’s writing about his investment in Gen Re. This is a serious omission in my view. Gen Re was by far Buffett’s largest investment, and the company lost over $7 billion dollars in the early years that he owned it. Buffett’ trenchant comments about the losses represent a very public statement about what he learned from the experience, clearly one of the more significant of the losses he faced. His pointed comments about the reason for the losses underscore some of his most important business principles.

It is also a personal gripe that though this volume omits Buffett’s writings generally about insurance, somehow the book manages to include every single instance where Buffett has said that his company does not carry D&O insurance. I have always thought that these statements are dangerous for mere ordinary mortals. It is fine for Buffett and his billionaire board members to disdain D&O insurance, but persons of more ordinary means can ill afford to run the risk of uninsured board service. Every time I read Buffett’s comments about D&O insurance, I feel like they should include a warning that “Readers should be cautioned to recall that he is one of the wealthiest people on the planet and his personal net worth is greater than the policyholders' surplus of most insurance companies’; readers should not attempt this trick at home.”

While I think this volume of essays is a worthy introduction to Buffett’s views and business philosophy, a lot of the writing will lack context for many readers. To know why Buffett quotes Ben Graham, and what he means by it, it is really necessary to understand more about Buffett’s days in graduate school and his early days working for Graham. His comments about many of his investments, such as Capital Cities/ABC or Solomon Brothers, require a great deal of prequel and sequel in order to appreciate fully what Buffett is saying. So I would recommend as a companion to this volume of essays Roger Lowenstein’s excellent biography of Buffett (here). Even though Lowenstein’s book is now 13 years old, it still conveys a lot about how Buffett got there, which is of course what most people – like those investing docs who attend the Berkshire annual meeting every year – are interested in.

But these last quibbles with the content, such as they are, are minor. The book itself is quite an accomplishment; it is that rare business book that is worthwhile and entertaining and enjoyable to read.

Special thanks to Professor Cunningham for calling my attention to the book.

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Warren Buffett’s annual letter to Berkshire Hathaway shareholders has become a capitalist cult classic, eagerly awaited each year not only by Berkshire shareholders but also by a broader audience of readers keen to read Buffett’s observations about both his company and the larger business and economic environment. This year’s letter (here), issued after market close on February 29, 2008, does not disappoint, as it brims with commentary on a variety of matters, as well as about the performance of Berkshire itself. But to an unusual extent, this year’s letter may be as noteworthy for what it omits as for what it includes, as I discuss further below. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.)

Buffett’s letter is of course a part of the Berkshire 2007 annual report, and the letter does contain quite a few interesting nuggets about Berkshire. Even though Buffett seemingly goes out of his way to detail his past investing errors (particularly emphasizing his failed Dexter Shoes investment as well as his failure to buy a Dallas TV station), the overall effect is to reinforce Buffett’s astonishing investing success. For example, after documenting his lapses at length, he almost parenthetically mentions the company’s 2007 sale of its 1.3% interest in PetroChina, acquired during 2002 and 2003 for $488 million, for which Berkshire received $4 billion – a staggering 820% gain in approximately five years.

On the other hand, Buffett’s letter also emphasizes that although Berkshire’s insurance businesses had another “excellent year” in 2007 (producing underwriting profit of $3.37 billion, on top of $3.8 billion in 2006), it is “a certainty that insurance industry profit margins, including ours, will fall significantly in 2008.” Buffett’s bases for this conclusion are that “prices are down and exposures inexorably rise.” If natural catastrophes occur, “results could be far worse.” Buffett warns Berkshire’s shareholders “to be prepared for lower insurance earnings during the next few years.”

Buffett also provides a detailed explanation of Berkshire’s growing derivatives exposure. The existence of these contracts in Berkshire’s portfolio may strike some as contradictory, as Buffett has for years railed against derivatives as, among other things, “financial weapons of mass destruction” (as he called them in his 2002 shareholders’ letter). He has bemoaned for years the losses Berkshire sustained in winding down Gen Re Securities derivatives operation (on which Buffett reported in his 2006 letter that Berkshire had sustained a cumulative pre-tax loss of $409 million).

Buffett nevertheless reports in this year’s letter that Berkshire had entered a total of 94 derivative contracts (up from 62 in 2006), apparently in the form of credit default swaps and futures put options on four stock indices. (The stock indices put represents a bet that these indices will close at far-forward dates at levels above where they stood when Berkshire entered the contracts.) While Buffett’s willingness to enter these contracts seems surprising given his long-standing and often-expressed hostility to derivatives generally, he emphasizes that with respect to each of the contracts, Berkshire is holding the cash – which means not only that Berkshire has no counterparty risk, but also that Berkshire has the opportunity to earn investment income in the interim. It is also important to contrast Berkshire’s current portfolio of 94 derivative contracts with the 23,318 contracts that were formerly held by Gen Re Securities. 

Buffett does warn that the mark-to-market accounting required on the derivative contracts “will sometimes cause large swings in reported earnings.” Buffett compares this exposure to Berkshire’s catastrophe insurance exposure and Berkshire’s long-standing willingness to “trade volatility in reported earnings in the short run for greater gains in net worth in the long run.” I have more to say below about Buffett’s comparison between the derivatives portfolio and Berkshire’s catastrophe reinsurance business.

Buffett’s commentaries about Berkshire’s performance are interesting, but Buffett’s letters are valued for far more than their observations on Berkshire’s own performance. Most readers scour Buffett’s letters for his discourse on larger topics, and his most recent letter has much to offer in that regard. In this year’s letter, Buffett returns to some of his familiar themes and also launches into some new topics.

The first familiar theme Buffett sounds relates to problems in the residential mortgage sector. Buffett commented on this topic in last year’s letter, where he decried “weakened lending practices” and mortgage loan structures that subjected borrowers to potentially escalating repayment obligations. In this year’s letter, Buffett has a “told-you-so” tone when he references the “staggering problems” that “major financial institutions” have recently experienced. He comments that “our country is experiencing widespread pain” because of the “erroneous belief” that “house price appreciation” would “cure all problems.” Buffett notes that

As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide does out – and what we are witnessing at some of our largest financial institutions is an ugly sight.

Another recurring theme Buffett revisits in this year’s letter is the U.S. trade deficit and its impact on the dollar’s valuation. In last year’s letter, while reporting on Berkshire’s direct foreign exchange gains, he bemoaned the U.S.’s transformation into a net debtor country as a result of which the country is now shipping “tribute” overseas in the form of an interest income burden that finances what he called U.S. “over-consumption.” Buffett returns to this topic in this year’s letter, specifically commenting on how these circumstances have led to the emergence of sovereign wealth funds:

There has been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot of foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here.  Why should we complain when they choose stocks over bonds?

In last year’s letter, Buffett did note that Berkshire had “come close to eliminating our direct foreign exchange position,” on which Berkshire had earned roughly $2.2 billion between 2002 and 2006 in investments in 14 different currencies. In this year’s letter, Buffett notes that in 2007 Berkshire had only one direct currency position, in the Brazilian real. Buffett also noted that Berkshire had invested in bonds denominated in currencies other than dollars, citing as a specific example euro-denominated Amazon.com bonds Berkshire purchased in 2002 for $162 million, that were redeemed in 2007 for $253 million (having paid 6 7/8 % interest in the interim).

Yet, Buffett emphasizes, Berkshire’s assets “will always be concentrated in the U.S.,” citing as justification “America’s rule of law, market-responsive economic system, and belief in meritocracy,” which Buffett contends, “are almost certain to produce ever-growing prosperity for its citizens.”

One standard feature of Buffett’s annual letter is a penultimate portion in which he skewers some particular foible of the financial scene. Last year, Buffett targeted the “2-and-20 crowd” of hedge fund “helpers” whose fees enrich themselves at their clients’ expense. This year, in a section of the letter captioned “Fanciful Figures – How Public Companies Juice Earning,” Buffett targets “the investment return assumption a company uses in calculating pension expense.”

Buffett notes that the 2006 average assumed pension return among the 363 S & P companies that have pensions is 8%. Buffett compares this assumed 8% return to the 5.3% average annual increase in the Dow Jones average during the 20^th century. In order for the Dow Jones average to continue to grow at just a continued 5.3% annual rate in the 21^st century, the Dow Jones average would have to close at 2,000,000 on December 31, 2099. And the companies that are projecting a 10% return “are implicitly forecasting a level of about 24,000,000 on the Dow by 2100.” Buffett characterizes the “helpers” who make these kinds of assumptions as “direct descendants of the Queen in Alice in Wonderland” who has “believed as many as six impossible things before breakfast.”

The reason for these high investment return assumptions, Buffett notes, “is no puzzle,” as they allow CEOS to “report higher earnings,” securing the knowledge that “the chickens won’t come home to roost until long after they retire.”

Having disparaged corporate pension fund accounting, Buffett then moves on to “public pension promises” for which “funding is woefully inadequate.” The “fuse on this time bomb is long,” but the promises that politicians find so easy to make “will be anything but easy to keep.”

Buffett’s annual letter is always entertaining and informative, and this year’s letter is no exception. But it strikes me that there are omissions from this year’s letter, some of which seem to me to be particularly conspicuous.

First, Buffett’s letter makes absolutely no reference to the recent “finite reinsurance” criminal trial that resulted in guilty verdicts against four former Gen Re officials (as well as one former AIG officer). Buffett’s silence on this matter is at one level understandable, as his name did arise in trial testimony, and as news reports suggest (here) that the criminal investigation is continuing. But given the fact that the former CEO and former CFO of Berkshire’s largest subsidiary were found guilty of criminal wrongdoing, Buffett’s lack of any reference to the verdicts (even to say that he could not comment) seems like a significant omission.

Buffett did implicitly draw a seeming contrast between prior Gen Re management (the ones on trial) and current Gen Re management; Buffett said that current management is doing “first-class business in a first-class way” despite “costly and time consuming legacy problems.” Buffett also commented that he learned to his regret that when he acquired Gen Re in 1998, it was no longer the “Tiffany of reinsurers” as it had been previously. Buffett made similar comments in the 2001 and 2002 Berkshire annual reports. (Full disclosure: I was for ten years an employee of a Gen Re operating subsidiary, and for that reason I feel obliged to forebear from any further commentary on these circumstances.)

Second, other than commenting on the mortgage lending industry’s lamentable shortcomings, Buffett provides no further commentary on the subprime crisis. Other insurers reporting their earnings in recent weeks have felt compelled to address both their potential insurance loss exposure to subprime-related liabilities and their companies’ investment portfolio vulnerability to subprime investment losses. On the one hand, Buffett’s credibility is such that if Berkshire had significant exposure in these areas, we would all expect him to have said something about it. On the other hand, given the prominence of these issues, it does not seem too much to have expected him to address these issues, and, again, his failure to comment on these topics seems like an omission.

Third, and related to the topic of subprime, Buffett’s letter makes no reference to Berkshire’s recent high profile entry into the municipal bond insurance business, in the wake of turmoil involving the traditional monoline insurers. While we may perhaps look forward to reading about this development in next year’s letter, this initiative did unfold in late 2007, and I would have expected some commentary about it in this year’s letter, especially given the high profile nature of the move.

But while Buffett did not mention Berkshire’s move into municipal bond insurance, his commentary on the problems public pension funds may face does put Berkshire’s move into providing municipalities with default guarantee protection in an interesting perspective. As Floyd Norris of the New York Times observes on his blog, Notions on High and Low Finance (here), “Why, you might wonder, would Mr. Buffett want to put Berkshire Hathaway into the business of insuring municipal bonds issued by such governments?”

One final apparent omission from Buffett’s letter is that he does not mention Berkshire’s recent acquisition of 3% interest in Swiss Re, or Berkshire’s agreement to assume 20% of Swiss Re’s property and casualty reinsurance business for the next five years. (Refer here for background on these transactions.) On the one hand, the Swiss Re transactions represent 2008 business, and so I suppose we should just be patient and wait until next year’s letter to see what Buffett says about the transactions. But the particular reason that Buffett arguably ought to have discussed the Swiss Re transactions, and in particular the timing of the Swiss Re transactions, is his commentary in this year’s letter about the likely future prospects of the insurance industry. I agree with Buffett that we should all “be prepared for lower insurance earnings over the next few years.” Given these prospects, the timing of the Swiss Re transactions cries out for further explanation.

A Final Observation: Perhaps others might be unwilling to find any relation between the two companies’ respective positions, but I find Berkshire’s increased derivatives exposure somewhat disconcerting in light of AIG’s recent $11.2 billion mark-to-market derivatives portfolio write-down. It may also fairly be argued that Berkshire’s volatility exposure is much smaller than is AIG’s. But after years of Buffett’s lectures about the evils of derivatives, Berkshire’s growing derivatives exposure seem incongruous.

Questions may also be raised about the appropriateness of the analogy Buffett draws between Berkshire’s volatility exposure as a catastrophe reinsurer and the potential volatility from Berkshire’s growing derivatives portfolio. The Wall Street Journal’s March 1, 2008 Breaking Views column (here) put its finger precisely on the problem in its commentary on AIG’s write-down, by pointing out that logical shortcoming of insurers’ putative qualifications to assess and accept risk from these financial instruments:

Insurers say they are experts at managing just this sort of high-severity, low-probability risk. They argue that insuring against floods, hurricanes, and earthquakes has given them peerless expertise in managing it.

But since there’s no market in acts of nature, insuring against them can’t lead to massive mark-to-market write-downs, as financial exposures can. And there’s a big difference between acts of nature, which can be modeled statistically, and the behavior of complex structured-finance instruments packed with assets that have little historical performance data, which frequently confounds statisticians.

The Journal column ends with the observation that “AIG isn’t alone in falling for this false analogy.” 

To be sure, Buffett did not claim that Berkshire’s expertise in underwriting catastrophe reinsurance qualified the company to underwrite derivatives, only that Berkshire’s willingness to accept the volatile results of catastrophe reinsurance was comparable to its willingness to accept volatile impacts from its derivatives portfolio, in exchange for the long run net worth benefits.

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It is now a well-established part of the mythology of American capitalism that Warren Buffett still lives in the same modest brick colonial in Omaha, pictured above, that he bought in 1958 for $31,000. (According to Forbes magazine's annual survey of billionaires' houses, here, Buffett's home had a 2003 tax valuation of $700,000.) Intuitively, we believe that the relative modesty of Buffett's home tells us something about his values and priorities, just as we all probably make certain assumptions about the values and priorities of the occupants of the truly execrable miniature Versailles mansions that have sprouted in recent years on the far-flung fringes of most American cities --even Cleveland, for God's sake!

In one of the more interesting and entertaining articles I have read in a long time, Crocker Liu of the Arizona State University Business School and David Yermack of N.Y.U. Business School take a look at what else the size and valuation of CEOs' homes might tell us. In their March 2007 article entitled "Where Are The Shareholders' Mansions? CEOs' Home Purchases, Stock Sales, and Company Performance" (here), the authors' "central research question concerns the association between CEO real estate purchases and subsequent performance of their company."

The authors developed their hypotheses by questioning whether a CEO's home purchase more nearly indicates the CEO's commitment to their company and its community, or rather represents the CEO's "entrenchment," particularly if the CEO is unconcerned about liquidating their assets (especially their holdings in company shares) and investing in an expensive home so as to provide "a public signal about the executive's status and security."

In order to determine which hypothesis is accurate, the authors undertook some rather creative detective work to identify the homes of the CEOs of the S & P 500 companies (including, among other things, each home's location, size, valuation, date of acquisition, and method of financing). The authors ultimately were able to identify the homes of 488 of the CEOs, 164 of which the CEOs had acquired after taking office.

What the authors found out about the CEOs' homes is fascinating. The median CEOs' home is more than 5,600 square feet, and sits on over one and a quarter acres. The median 2006 market valuation of the CEOs' homes is $2.7 million (although this may be understated because some of the homes are sufficiently unique that there are no ready market valuations). 12% of CEOs' homes are on the waterfront, and 8.5% are on golf courses. The median distance from the office for CEOs' homes is 12.5 miles, but 16 of the CEOs live more than 1,000 miles from their company headquarters and another 16 live between 250 and 1,000 miles from their office.

With respect to the question about the correlation between the CEO's home purchase and company performance, the authors found that when a CEO buys a home, "future company performance is inversely related to the CEO's liquidation of company shares and options" to finance the transaction, even if the stock sales are small relative to the CEO's holdings. The authors also found that "future performance deteriorates when CEOs acquire extremely large or costly mansions or estates," regardless of the method of financing. The authors found a "significantly negative stock performance following the acquisition of very large homes by company CEOs," a negative trend that persists for several years after the home purchase.

The authors' assessment of this finding is that the CEO who purchases his or her home without selling shares is perhaps signaling their commitment to the company and expectation of future stock returns. The CEO who liquidates his or her shares to finance their home purchase , or buys a very expensive home, is signaling his or her perception of his or her status and security, and therefore the purchase represents a proxy for CEO "entrenchment."

The authors contend that these facts suggest an investment strategy, essentially shorting the shares of companies whose CEOs who acquire very large and expensive homes, but maintaining long positions on the companies whose CEOs acquired their homes without selling company shares. According to the authors, both ends of this strategy would substantially outperform the companies taken as a whole.

I find the authors' work intriguing, but I wonder whether the apparent link between the CEO's home valuation and corporate performance might not be a manifestation of what a former colleague of mine poetically calls "multicollinearity." That is, is the inverse correlation between CEO home valuation and corporate performance simply the quantification of another phenomenon - for example, the level of CEO compensation?

For the record, Buffett's home was not among the houses the authors studied, since Berkshire Hathaway inexplicably is not a part of the S & P 500. The authors' data set also does not include Bill Gates' $140 million, 66,000 square foot home, since he is no longer the CEO of Microsoft. Steve Ballmer's $8 million, 4,100 square foot home was included, however.

I am hoping that the authors' next article will compare the valuations of CEOs homes to those of the leading securities class action plaintiffs' lawyers. I suspect it would provide even more interesting analysis.

One of the Internet tools the authors used is the website, Zillow.com (here). If you have never visited the site, drop what you are doing immediately and go there. Just be prepared to spend the next few hours figuring out how much you neighbors', friends', and acquaintances' houses are valued for. Unless you really don't find things like that interesting at all. (Right...) Coincidentally, the April 4, 2007 Wall Street Journal reports (here, subscription required) that Zillow.com CEO Richard Barton is currently attempting to sell his Seattle home for $2.6 million (marked down from the intial asking price of of $3.475 million).

Special thanks to an alert reader (who prefers anonymity) for the link to the article.

Adults Only: When my oldest daughter was eight years old, she expressed an interest in reading The Hunchback of Notre Dame. (For reasons that no one who has actually read the book could possibly explain or understand, Disney had just released a childrens' cartoon movie based on the book.) I told her that I did not believe the book was appropriate for children. She of course asked why, and I told her that the book deals with "adult themes." She cocked her head at me and squinted her eyes and said, "You mean like real estate?"

Yes, like real estate. Exactly.

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For years, Warren Buffett's annual Letter to Berkshire Hathaway shareholders has been a trove of business insight and commercial wisdom, and this year's letter (here), released on March 1, 2007, is no exception. While the general focus of the letter is a year-end review of the various Berkshire businesses, Buffett still managed to work in some memorable observations about some larger topics. I review below several of his comments, as well as one substantial omission from the letter to shareholders. (Full dislosure: I own Berkshire shares, although not nearly as many as I wish I did.)

Executive Compensation: After noting that he has been on 19 corporate boards and that he sets the compensation for the CEOs of "around 40 significant operating businesses," he has nonetheless faced "ostracism" from the compensation committees of the boards on which he has served, perhaps because he takes a different view on executive compensation. His concern is that there is a pack mentality on executive compensation, driven by compensation consultants, which results in the following:

CEO perks at one company are quickly copied elsewhere. "All the other kids have one" may seem a thought too juvenile to use as a rationale in the boardroom. But consultants employ precisely this argument, phrased more elegantly of course, when they make recommendations to comp committees.

Buffett is not optimistic about changing these practices, either; he says that "irrational and excessive comp practices will not be materially changed by disclosure or by an independent comp committee." Buffett asserts that true comp reform will take place only "if the largest institutional shareholders...demand a fresh look at the whole system." Buffett is skeptical that the fresh look will never take place as long as compensation is engineered by comp consultants who are "deftly selecting 'peer' companies," a practice that will only "perpetuate present excesses."

Hedge Funds: Using the example of the wealthy, fictitious Gotrocks family, Buffett examines the way that an investment industry of "helpers" is diverting (rather than creating) wealth through imposition of outsized management fees and other costs. Buffett has particular contempt for the "2-and-20 crowd" that charges 2% of principal and 20% of profit, ensuring enormous fees to the "helper" but inferior returns to investors:

The inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have been had it never heard of these "hyper-helpers." Even so, the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.

Dollar Weakness and U.S. Indebtedness: After reviewing the $2.2 billion profit Berkshire earned between 2002 and 2006 from its direct foreign-exchange position (i.e., Berkshire was long on foreign currencies), Buffett reviewed the reasons why Berkshire will continue to attempt to gain from foreign currency exposure, either from "the ownership of foreign equities or of U.S. stocks with major earnings abroad." Buffett expects to gain as the dollar continues to weaken, which he expects because of the massive level of U.S. imports that are not reciprocated by export sales - as a result of which "the U.S. has necessarily transferred ownership of its assets or IOUs to the rest of the world." The U.S. can do this because "we are an extraordinarily rich country that has behaved responsibly in the past." But Buffett believes that this imbalance and outflow of assets and wealth has its consequences, some of which are potentially very dangerous:

our citizens will also be forced every year to ship a significant portion of their current production abroad merely to service the cost of our huge debtor position. It won't be pleasant to work part of each day to pay for the over-consumption. of your ancestors. I believe that at some point in the future U.S. workers and voters will find this annual "tribute" so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict - but to expect a "soft landing" seems like wishful thinking.

PetroChina and Darfur: Consistent with Buffett's commitment going forward to foreign equities, Berkshire has a substantial investment in PetroChina, which is China's biggest producer of oil. According to his letter to shareholders, as of December 31, 2006, Berkshire owned 2.3 billion shares of PetroChina Class H shares (representing 1.3% of the company and making Berkshire the company's largest foreign shareholder), which have a cost basis of $488 million but a market value of $3.3 billion, or a current value of 670% of cost. (Buffett obviously has not lost his eye for a bargain.)

Interestingly, Buffett elected to say nothing in his letter to shareholders about Berkshire's investment in PetroChina, which has come under fire recently (refer here) for its 40 percent investment in a Sudanese oil venture. (The allegation is that the venture supports the Sudanese government, which is responsible for genocide in the Darfur region. Based on these concerns, Harvard and Yale, among others, have divested their shares in PetroChina.) Perhaps to avoid the necessity for Buffett to address this topic in his shareholder's letter, Berkshire released a statement (here) the week before the letter was published. Essentially, Berkshire's response is that it is not PetroChina, but PetroChina's controlling shareholder China National Petroleum Corporation (owned by the Chinese government) that has operations in Sudan. PetroChina itself does not, and the subsidiary can't control the parent.

A February 23. 2007 Salon.com column entitled "Warren Buffett Plays Dumb in Darfur" (here) criticizes Berkshire's response for ignoring the true relationship between PetroChina and CNPC - specifically, that the executive team for both companies consists of exactly the same individuals in the same functions with the same titles. The Salon.com article asserts that "to declare, as Berkshire does, that a subsidiary has no ability to control the policies of the parent, when the two entities are run by the exact same people, is an exercise in specious obfuscation."

The D & O Diary is in no position to judge the merits of the PetroChina dispute. But it has been my observation that commentators have been more hostile toward Buffett since he started his very public bet against the dollar a few years ago. As his investment approach has moved beyond foreign currencies to foreign equities and other foreign assets, media commentators, who idealized him for so long as the "Oracle of Omaha," are now likelier to demonize him. Buffett's strategy to go long on foreign assets because of his bearish views on the U.S. dollar will likely make him increasingly unpopular. Perhaps Buffett himself is experiencing his own form of "backlash" of the kind he anticipated in his shareholder's letter's comments about the fallout from U.S indebtedness. Unlike Buffett himself, many are unable (or unwilling) to regard his decision to invest in foreign assets as the neutral pursuit of superior investment returns. I suspect that going forward Buffett will find himself dogged by similar questions like those surrounding Berkshire's PetroChina investment.

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