We Need a New Oracle

Warren Buffett was on CNBC for three hours on March 9, 2009, dishing out his wisdom. All this fanfare despite having lost $24 billion in value last year, and handing the title of Richest Man in the World over to Bill Gates. Buffett made multiple references to “war” in describing the current financial crisis.

There are several problems with Buffett’s comparison of the current state of the economy to war, as pointed out in this story in the Omaha World-Herald, which ran the day after the interview. What we are seeing is less like war – in which an outside enemy attacks you – and more like arson, except the people who burned down the house are now collecting the insurance too!

Warren Buffett – the widely revered Oracle of Omaha, where I live – is one of those who built the boom in the capital markets and are benefiting from the bust. No surprise then that Buffett whose primary business vehicle is Berkshire Hathaway, a financial holding company, supports the bailout of financial institutions. Their business includes, among others, property and casualty insurance and a financial holding company. When Senator Ben Nelson (D-NE) told me that he talked with Warren before voting for the first bailout package, I button-holed him after lunch and gave him an ear full.

Of course Buffett was in favor of the bailout – his companies directly benefited as did the investments made by his companies. He put $5 billion into Goldman Sachs preferred stock with a 10% dividend – a substantially better rate of return than the US government got on our $10 billion bailout, er, I mean “investment.” Berkshire Hathaway was the largest shareholder in American Express Co. when they received $3.4 billion from Uncle Sam.

Buffett appeared on CNBC a year ago (March 3, 2008). At that time he was forthcoming about the risks Berkshire Hathaway was taking. He told CNBC at the time that he had “written 206 transactions in the last three weeks” which were default swaps on municipal bonds – the financing used by cities and states to fund everything from building schools to general obligations.

Buffett bragged that “the municipality has to quit paying” before any losses would have to be covered. This gives him incentive for another payout from Uncle Sam in addition to the Wall Street bailout – he also has incentive to support the stimulus package. If the cities and states default on their debt, then Buffett (Berkshire Hathaway companies) would be on the hook to make good on the full value of the bonds. At that point in March 2008, after just 3 weeks of investing, Buffett said he made $69 million in premiums for guaranteeing payment on $2 billion of municipal bonds. The primary insurer received about $20 million, an amount significantly less but that carries more risk. If that doesn’t seem to make sense, then you understand – the pricing of risk and premiums did not make sense. This systematic irrationality was also a contributing factor to the current financial mess.

The scheme of buying and selling bond payment guarantees is very much dependent on rising asset prices (and no recession), just like any Ponzi scheme. Describing his investment strategy in March 2008, Buffett clearly said that what he and the other insurers in this market are “hoping for is new money.” He even admitted that getting new money was preventing he and others in the market from having to “totally face(d) up to the mistakes that they've made.”

By now, Bernie Madoff has shown you how a Ponzi Scheme falls apart in a down market. In the 2008 interview, Buffett gave us a preview of what keeps him awake at night. Cities and states don’t go broke very often, but when they do “it could be contagious.” Luckily for Buffett, the Congress – “the best Congress that money can buy”, according to Sen. Kennedy – voted to send “stimulus” money to the cities and states.

In fact, Buffett wouldn’t have to pay on any of those bonds unless the primary bond insurer went broke, too. That primary bond insurer is Ambac Financial Group, Inc. Ambac is the first to pay in the event of default on the municipal bonds that Buffett is guaranteeing. If any of the bonds go bad, Ambac has to pay the bondholders. If Ambac got into financial trouble Buffett said he would “be out trying to help them raise money” – otherwise Berkshire Hathaway would have to pay off the bonds. Now, in March 2009, Buffett talks about the economy going over a cliff while Ambac teeters on the edge of junk bond status. When it falls, it could take Berkshire Hathaway with it. The table below shows what happened to Ambac’s credit rating between Buffett’s two appearances on CNBC.

Timeline of Ambac Credit Rating Slide

Acting selfish and self-serving is what got us into this mess in the first place. We’ve been witness to bloated executive compensation in the face of lousy corporate performance. We’ve seen mega-billionaires living lavish lifestyles for years on the proceeds of Ponzi schemes and fraud. Maybe it’s time for a new Oracle, in Omaha or elsewhere, because this one has been giving us bad advice.

Susanne Trimbath, Ph.D. is CEO and Chief Economist of STP Advisory Services. Her training in finance and economics began with editing briefing documents for the Economic Research Department of the Federal Reserve Bank of San Francisco. She worked in operations at depository trust and clearing corporations in San Francisco and New York, including Depository Trust Company, a subsidiary of DTCC; formerly, she was a Senior Research Economist studying capital markets at the Milken Institute. Her PhD in economics is from New York University. In addition to teaching economics and finance at New York University and University of Southern California (Marshall School of Business), Trimbath is co-author of Beyond Junk Bonds: Expanding High Yield Markets.