BHLC: 2008 Notes and Reviews of Berkshire Hathaway Shareholder Letter

Notes on Berkshire Hathaway Shareholder Letter from 2008

Brief Summary of the Year:

This has been, hands down, my favorite article so far. It’s probably because this was a year I remember very well and there were economic events unfolding that I never fully understood.

This is hands down the best thing I’ve ever read to really get down to the core of what was happening with the government bailout of 2008. It’s fascinating stuff.

It’s also great to experience Buffett in a down year. He’s always winning and even in the years which he looses, he keeps to his principles and seems honest with his appraisal of his job for the year.

Notes For the Year:

Our decrease in net worth during 2008 was $11.5 billion. – Warren Buffett

This is the first year (that I’ve read) in which Warren didn’t record growth in value. This will be interesting to read as it will give a great description of how a great investor deals with inevitable losses.

This [2008 financial system meltdown] debilitating spiral has spurred our govern- ment to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome after effects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.
 
Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly. – Warren Buffett

On the government bail-outs of 2008 and understanding the level of involvement the government had to take to keep the system from failing.

Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (oneof which we initially appeared to be losing); a dozen or so panics and recessions;virulent inflation that led to a 211⁄2% prime rate in 1980; and the Great Depress-ion of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges. – Warren Buffett

Ever the optimist Warren Buffett is. He notes that this isn’t the biggest challenge the US has ever faced…

Though the path has not been smooth, our economic system has worked extraordinar- ily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead. – Warren Buffett

Warren Buffett on the long term sustainability of the US economic system (or/and the world economic system.)

In good years and bad, Charlie and I simply focus on four goals:

        • (1) maintaining Berkshire’s Gibraltar-like financial position, which features huge amounts of excess liquidity, near-term obligations that are modest, and dozens of sources of earnings and cash;

 

 

      • (2) widening the “moats” around our operating businesses that give them durable competitive advantages;

 

 

      • (3) acquiring and developing new and varied streams of earnings;

 

 

      • (4) expanding and nurturing the cadre of outstanding operating managers who, over the years, have delivered Berkshire exceptional results.

 

– Warren Buffett

Again, reiterating the points Buffett considers so important. Management, Moats, New Income steams and big positions, extra money and low obligation.

Buffett notes that the earnings of businesses connected to the overall economy suffered during this period but the businesses less directly related to the overall economy did great.

Again, the insurance business did great:

Nevertheless, the insurance group delivered an underwriting gain for the sixth consecutive year. This means that our $58.5 billion of insurance “float” – money that doesn’t belong to us but that we hold and invest for our own benefit – cost us less than zero. In fact, we were paid $2.8 billion to hold our float during 2008. Charlie and I find this enjoyable…
 
…our insurance operation, the core business of Berkshire, is an economic powerhouse.- Warren Buffett

Funny. Also, they get paid on every step of the way. Great business model.

Price is what you pay; value is what you get. – Ben Graham

Buffett goes on to discuss various businesses. MidAmerican, a real estate brokerage conglomerate that operates pipelines as well.

PacifiCorp was a 2006 purchase that has grown from 33 megawatts to 794 by this period while decreasing employees by 2%

Our long-avowed goal is to be the “buyer of choice” for businesses – particularly those built and owned by families. The way to achieve this goal is to deserve it. That means we must keep our promises; avoid leveraging up acquired businesses; grant unusual autonomy to our managers; and hold the purchased companies through thick and thin (though we prefer thick and thicker). – Warren Buffett

As always, the Berkshire Hathaway commitment to being a good buyer of businesses is powerful.

Buffett essentially bashes “private equity” firms as being fee rich and loading companies with bad debt. Now, that the economy is in a slump, these firms hold all their cash when it would be best for the businesses if they deployed the cash.

Again, Buffett is enamored with GEICO. For each employee at GEICO there were 299 policies in 2003, at this period there are 439 per employee. Efficiency has been the key to their massive success. Lower cost, high value.

General Re, our large international reinsurer, also had an outstanding year in 2008. Some time back, the company had serious problems (which I totally failed to detect when we purchased it in late 1998). By 2001, when Joe Brandon took over as CEO, assisted by his partner, Tad Montross, General Re’s culture had further deteriorated, exhibiting a loss of discipline in underwriting, reserving and expenses. After Joe and Tad took charge, these problems were decisively and successfully addressed. Today General Re has regained its luster. Last spring Joe stepped down, and Tad became CEO. Charlie and I are grateful to Joe for righting the ship and are certain that, with Tad, General Re’s future is in the best of hands. – Warren Buffett

Warren Buffett’s way of seeing a replacement in management along with the general theme on the importance of managers.

It’s crucial that insurance companies have a robust culture of underwriting, reserving and expensing.

A promise is no better than the person or institution making it. – Warren Buffett

Another core theme of Buffett’s letters is the importance of being your word.

“It’s difficult for an empty sack to stand upright. – Ben Franklin

Buffett brings this up to illustrate that because General Re is backed by Berkshire Hathaway (a company with mammoth amounts of capital at hand), they can back all their promises.

To begin with, the need for meaningful down payments was frequently ignored. Some-times fakery was involved. (“That certainly looks like a $2,000 cat to me” says the salesman who will receive a $3,000 commission if the loan goes through.) Moreover, impossible-to-meet monthly payments were being agreed to by borrowers who signed up because they had nothing to lose. The resulting mortgages were usually packaged (“securitized”) and sold by Wall Street firms to unsuspecting investors. This chain of folly had to end badly, and it did. – Warren Buffett

Warren Buffett summing up the poor mortgage behavior and even more scandalous behavior of wall street selling the securities.

He then goes into discussing Clayton homes and says that they didn’t participate in the poor mortgage behavior like the rest of the financial industry.

Why are our borrowers – characteristically people with modest incomes and far-from-great credit scores – performing so well? The answer is elementary, going right back to Lending 101. Our borrowers simply looked at how full-bore mortgage payments would compare with their actual – not hoped-for – income and then decidedwhether they could live with that commitment. Simply put, they took out a mortgagewith the intention of paying it off, whatever the course of home prices. – Warren Buffett

Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one. – Warren Buffett

We wrote this “second-to-pay” insurance for rates averaging 3.3%. That’s right; wehave been paid far more for becoming the second to pay than the 1.5% we would haveearlier charged to be the first to pay. In one extreme case, we actually agreed tobe fourth to pay, nonetheless receiving about three times the 1% premium charged by the monoline that remains first to pay. In other words, three other monolines have to first go broke before we need to write a check. – Warren Buffett

After this statement, Buffett goes on to describe the dangerousness of the business. Essentially, they are ensuring that bonds will be paid, but if bonds aren’t paid on a large scale, the decision on how to sort the problem out will fall on government which will be likely to side with the people rather than the bond insurance holder.

Investors should be skeptical of history-based models. – Warren Buffett

Our advice: Beware of geeks bearing formulas. – Warren Buffett

I still believe the odds are good that oil sells far higher in the future than thecurrent $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars. – Warren Buffett

Regarding the purchase of ConocoPhillips, Buffett bought an oil and gas company right when oil and gas prices were at their apex.

Beware the investment activity that produces applause; the great moves are usuallygreeted by yawns. – Warren Buffett

Timeless investing advice I believe.

Derivatives are dangerous. They have dramatically increased the leverage and risksin our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive miss-statements of earnings for years. So indecipherable were Freddie and Fannie that their federal regulator, OFHEO, whose more than 100 employees had no job except the oversight ofthese two institutions, totally missed their cooking of the books. – Warren Buffett

The mistakes Freddie and Fannie were making were so tremendous that the government couldn’t even see them. Despite the fact that they were the most heavily regulated organizations in the US, they still were able to create tremendous problems that went under the radar of all the regulators.

Warren Buffett on what happened in 2008 with the financial derivatives market and why it’s so dangerous to have derivative contracts on the books.

A normal stock or bond trade is completed in a few days when one party getting itscash, the other its securities. Counterparty risk therefore quickly disappears, which means credit problems can’t accumulate. This rapid settlement process is keyto maintaining the integrity of markets. That, in fact, is a reason for NYSE and
NASDAQ shortening the settlement period from five days to three days in 1995.
 
Derivatives contracts, in contrast, often go unsettled for years, or even decades,with counterparties building up huge claims against each other. “Paper” assets andliabilities – often hard to quantify – become important parts of financial state- ments though these items will not be validated for many years. Additionally, a frightening web of mutual dependence develops among huge financial institutions. Receivables and payables by the billions become concentrated in the hands of a fewlarge dealers who are apt to be highly-leveraged in other ways as well. Participants seeking to dodge troubles face the same problem as someone seeking toavoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with.
 
Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it assures them government aid if trouble hits. In other words, only companies having problems that can infect the entire neighborhood – I won’t mention names – are certain to become a concern of the state (an outcome, I’m sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won’tdo; it’s mindboggling screw-ups that are required. – Warren Buffett

How it benefits the financial industry to take big, dangerous bets and share all the bad debt tools amongst each other. They created a situation where they were all in such a bad place that they were backed up by the government.

My belief that the CEO of any large financial organization must be the Chief Risk Officer as well. If we lose money on our derivatives, it will be my fault. – Warren Buffett

As always, Warren takes all the credit when he succeeds and fails in business. It’s ok for him to trade derivatives contracts because he monitors them and knows what’s happening.
It doesn’t work for the big financial firms and the government backed firms because when they build these derivatives contract portfolios that are largely created by people who are incentivized to buy more (via fees and commissions.) It’s a Moral Hazard to have others do it, for Buffett, it’s his name on the line so he has the moral incentive to get it right.

Black Scholes formula – This is a big one. Read the wikipedia to get it in your brain.

Buffett goes into describing 4 categories of contracts Berkshire holds. 1. Equity portfolio 2. Derivatives requiring Berkshire Hathaway when credit losses occur 3. Credit Default Swaps for corporations who can’t pay their debt. 4. Tax-exempt bond insurance contracts.

This is valuable stuff. When seeking an understanding of derivatives markets, I don’t think there is a better way to understand it than to read this passage.

– Thanks for Reading. I hope you found this helpful. Please feel free to leave a comment and contribute to the conversation.

Links I found while researching:

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