Buffett's comments on credit contraction and subprime market

**lzhang** Sun Aug 12, 2007 7:06 pm

Buffett's comments on credit contraction and subprime market
The following excerpts are from Whitney Tilson’s 2007 Berkshire Hathaway Annual Meeting Notes as of 05/05/2007

The Likelihood of a Major Credit Contraction

Buffett:
It occurred during the junk bond crisis in 2002 and for equities in 1974. I don’t think you’ll necessarily see a contraction of credit or the Fed stepping on the brakes. I think you might see an exogenous event, a shock to the system, that causes a huge widening of credit spreads and a cheapening of equities. This would be good for Berkshire because we have money to take advantage of this. In the past, when credit contracted, there was no money around. We tried to buy a bank in Chicago 30 or 40 years ago and couldn’t borrow at all. The only people willing to lend to us were in Kuwait, and would only lend in dinars. That was real credit contraction. The reason the Fed was established was in response to this. We really needed a system where that would not happen. I think the Fed will not by design produce any credit contraction.

Munger:
The last time we had a credit contraction [in the junk bond crisis in late 2002], we made a quick $3-4 billion. The whole investing world is getting more and more competitive. If we had a big credit contraction, it would really gum up the world. If we had this, especially after a period of excess like we’ve had, we’d get legislation that most of us wouldn’t like.

Buffett:
Jon Alter, in his book about the Great Depression [The Defining Moment: FDR’s Hundred Days and the Triumph of Hope], describes how this country was close to the brink and FDR got any law passed he wanted, as soon as he could write them. It was a good thing in this case – banks were closing and people were dealing in scrip.

In 1998, Long Term Capital Management blew up and you had a seize-up of the credit markets that was not orchestrated by the Fed. People panicked about even the safest instruments. This happened not 100 years ago but less than 10 years ago. There were plenty of smart people with a lot of money, but people panicked in part because they saw others panicking.

History doesn’t repeat itself, but it rhymes. We’ll have something that rhymes.

Comments on the Subprime Market

Buffett:
The subprime market, encouraged by lenders, intermediaries, builders, etc., led to a lot of people buying houses they couldn’t afford. There will be consequences for these people, but the question is whether it spreads. If unemployment and interest rates don’t go up, then it’s unlikely this factor alone triggers anything in the general economy.

In the 10Qs and 10Ks I’ve read, a high percentage of loans allowed people to make tiny payments early on, made up by higher payments later. I think this is dumb lending and dumb borrowing because someone who can only make 20-30% payments now isn’t going to be able to make 110% payments in the future. Those people and institutions were betting that house prices would keep going up. When this stops, you have a big supply of houses come on the market, like we saw in manufactured housing. You’ll see plenty of misery in that field – you’ve already seen some. But I don’t think it’ll be any huge anchor for the economy.

Munger:
There’s been a lot of sin and folly, a lot of it due to accountants who let lenders book profits when no one in their right mind would have allowed them to book profits. If accountants lie down on the job, you see huge folly.

It’s in the national interest to give loans to the deserving poor. But the moment you give loans to the undeserving poor or the stretched rich, you run into trouble. I don’t see how people did it and still shaved in the morning, because looking back at them was a face that was evil and stupid.

Buffett:
You’ve seen some very interesting figures in the past few months on people who didn’t even make the first or second payment. That shouldn’t happen. We saw this is in the manufactured-home sector. When someone only has to make a $3,000 down payment to someone who gets a $6,000 payment [the salesperson’s commission], then believe me, you’ll see a lot of bad behavior.

Securitization accentuated the problem. A local banker wouldn’t allow this because he’d see what’s going on, but when the loans are bundled and sold by Wall Street, that discipline disappears.

It will be at least a couple of years before real estate recovers. In some areas of the country, the [housing] inventory overhang is huge. The people who were counting on flipping the homes are going to get flipped, but in a different way.

References

http://www.tilsonfunds.com/Berkshire_Hathaway_07_annual%20meeting_notes.pdf

**lzhang** Sun Aug 12, 2007 7:41 pm

It is not hard to imagine Mr. Buffett is very busy at current situation, with billions of cash on hand. No wonder he can perform so well during bad times.

**baczhou** Tue Aug 14, 2007 9:32 pm

he must be happy to see this turmoil, and discussing buying strategies with his people. ；）

It seems buy BRK-B would be a good choice in currently situation.

**lzhang** Tue Aug 14, 2007 9:57 pm

See BRK filing as of today for holdings as of 06/30/2007

http://www.sec.gov/Archives/edgar/data/1067983/000095013407018234/a32912ce13fvhr.txt

I can only imagine he is busy buying more right now.

baczhou wrote: he must be happy to see this turmoil, and discussing buying strategies with his people. ；）