DIASPORA SPEAK

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What Warren thinks… (full article)

With Wall Street in chaos, Fortune naturally went to Omaha looking for wisdom. Warren Buffett talks about the economy, the credit crisis, Bear Stearns, and more. By Nicholas Varchaver

I know you had a paper route. Was that your first job?

Well, I worked for my grandfather, which was really tough, in the [family] grocery store. But if you gave me the choice of being CEO of General Electric or IBM or General Motors, you name it, or delivering papers, I would deliver papers. I would. I enjoyed doing that. I can think about what I want to think. I don’t have to do anything I don’t want to do. It might be wonderful to be head of GE, and Jeff Immelt is a friend of mine. And he’s a great guy. But think of all the things he has to do whether he wants to do them or not.

How do you get your ideas?

I just read. I read all day. I mean, we put $500 million in PetroChina. All I did was read the annual report. [Editor’s note: Berkshire purchased the shares five years ago and sold them in 2007 for $4 billion.]

What advice would you give to someone who is not a professional investor? Where should they put their money?

Well, if they’re not going to be an active investor – and very few should try to do that – then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They’re not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don’t buy all at one time.

How does the current turmoil stack up against past crises?

Well, that’s hard to say. Every one has so many variables in it. But there’s no question that this time there’s extreme leveraging and in some cases the extreme prices of residential housing or buyouts. You’ve got $20 trillion of residential real estate and you’ve got $11 trillion of mortgages, and a lot of that does not have a problem, but a lot of it does. In 2006 you had $330 billion of cash taken out in mortgage refinancings in the United States. That’s a hell of a lot – I mean, we talk about having $150 billion of stimulus now, but that was $330 billion of stimulus. And that’s just from prime mortgages. That’s not from subprime mortgages. So leveraging up was one hell of a stimulus for the economy.

If that was one hell of a stimulus, do you think the $150 billion government stimulus plan will make an impact?

Well, it’s $150 billion more than we’d have otherwise. But it’s not like we haven’t had stimulus. And then the simultaneous, more or less, LBO boom, which was called private equity this time. The abuses keep coming back – and the terms got terrible and all that. You’ve got a banking system that’s hung up with lots of that. You’ve got a mortgage industry that’s deleveraging, and it’s going to be painful.

The scenario you’re describing suggests we’re a long way from turning a corner.

I think so. I mean, it seems everybody says it’ll be short and shallow, but it looks like it’s just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don’t invest a dime based on macro forecasts, so I don’t think people should sell stocks because of that. I also don’t think they should buy stocks because of that.

Your OFHEO example implies you’re not too optimistic about regulation.

Finance has gotten so complex, with so much interdependency. I argued with Alan Greenspan some about this at [Washington Post chairman] Don Graham’s dinner. He would say that you’ve spread risk throughout the world by all these instruments, and now you didn’t have it all concentrated in your banks. But what you’ve done is you’ve interconnected the solvency of institutions to a degree that probably nobody anticipated. And it’s very hard to evaluate. If Bear Stearns had not had a derivatives book, my guess is the Fed wouldn’t have had to do what it did.

Do you find it striking that banks keep looking into their investments and not knowing what they have?

I read a few prospectuses for residential-mortgage-backed securities – mortgages, thousands of mortgages backing them, and then those all tranched into maybe 30 slices. You create a CDO by taking one of the lower tranches of that one and 50 others like it. Now if you’re going to understand that CDO, you’ve got 50-times-300 pages to read, it’s 15,000. If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared, you’re now up to 750,000 pages to read to understand one security. I mean, it can’t be done. When you start buying tranches of other instruments, nobody knows what the hell they’re doing. It’s ridiculous. And of course, you took a lower tranche of a mortgage-backed security and did 100 of those and thought you were diversifying risk. Hell, they’re all subject to the same thing. I mean, it may be a little different whether they’re in California or Nebraska, but the idea that this is uncorrelated risk and therefore you can take the CDO and call the top 50% of it super-senior – it isn’t super-senior or anything. It’s a bunch of juniors all put together. And the juniors all correlate.

If big financial institutions don’t seem to know what’s in their portfolios, how will investors ever know when it’s safe?

They can’t, they can’t. They’ve got to, in effect, try to read the DNA of the people running the companies. But I say that in any large financial organization, the CEO has to be the chief risk officer. I’m the chief risk officer at Berkshire. I think I know my limits in terms of how much I can sort of process. And the worst thing you can have is models and spreadsheets. I mean, at Salomon, they had all these models, and you know, they fell apart.

What should we say to investors now?
The answer is you don’t want investors to think that what they read today is important in terms of their investment strategy. Their investment strategy should factor in that (a) if you knew what was going to happen in the economy, you still wouldn’t necessarily know what was going to happen in the stock market. And (b) they can’t pick stocks that are better than average. Stocks are a good thing to own over time. There’s only two things you can do wrong: You can buy the wrong ones, and you can buy or sell them at the wrong time. And the truth is you never need to sell them, basically. But they could buy a cross section of American industry, and if a cross section of American industry doesn’t work, certainly trying to pick the little beauties here and there isn’t going to work either. Then they just have to worry about getting greedy. You know, I always say you should get greedy when others are fearful and fearful when others are greedy. But that’s too much to expect. Of course, you shouldn’t get greedy when others get greedy and fearful when others get fearful. At a minimum, try to stay away from that.