The AIG Bailout: Advice from Buffett, Munger and Grantham

It is incredible that AIG (AIG) gets taken over by the U.S. government as credit dries up. I want to share with you what Warren Buffett said at Berkshire's 2008 annual meeting:

Buffett: In fact, that was one of the interesting things that was said in testimony before the Senate finance committee. I think two of the witnesses (Bear Stearns) said: " We understood we couldn't borrow money unsecured if people started looking at us askance. But we never dreamed that we couldn't borrow money secured." Well we found that out at Solomonn 17 years earlier, when we were having trouble borrowing money secured. When the world doesn't want to lend you money, 10 or 20 or 50 basis points - or a bigger haircut on collateral - doesn't do much. They'll only lend you money if they want to lend you money.

And if you're dependent on borrowed money every day, you have to wake up in the morning hoping the world thinks well of you. And there was a period a couple of months ago when almost every investment bank in the United States was plenty worried about whether people were going to think well of them the next morning.

[Extracted from OID Aug 31, 2008 edition]

Also, Charlie Munger made excellent point on risk-aversion:

Munger: You can easily see how risk-averse Berkshire is. In the first place, we try and behave in such a way that no rational person is going to worry about our credit. And after we have done that, we also behave in such a way that if the world suddenly didn't like our credit, we wouldn't even notice it for months, because we have so much liquidity. That double layering of protection against risk is as natural as breathing around Berkshire. It's just part of the culture.

[Extracted from OID Aug 31, 2008 edition]

Jeremy Grantham wrote this in Jan 2008:

Grantham: About 2 years ago I was introduced to Hyman Minsky's argument on the development of credit bubbles. Remarkably, 'stability is unstable' really captures his point. Investors, when confronted with an apparent reduction in risk, will seek to return to their normal or desired risk by leveraging up. This attitude becomes contagious and reinforcing – risk is ignored and debt levels soar until at the peak capital gains are needed to merely pay the carrying costs. Then something, it doesn't really matter what, goes wrong; the risk in the environment is seen to return to more normal levels. Many players are caught with risk levels far above their desired level and are forced to cut back on leverage and risk in general, which puts pressures on the prices of what they own and so on. It has a simple and powerful logic. Well, the Minsky Meltdown has clearly arrived, and one shoe after another of the market centipede drops onto the floor, and we are waiting for many more. This is the most important U.S. financial crisis since World War II: it is of course far more global than previous crises, with tentacles reaching everywhere, and it coincides with broad overpricing of assets.

So, the take home messages:

• Excessive leverage kills. Just look at Bear Stearns, Freddie Mac (FRE), Fannie Mae (FNM), Lehman Brothers (LEH) and now, AIG. Thus, avoid excessive leverage and have plenty of liquidity like Berkshire Hathaway (BRK.A) and Fairfax Financial.
• Margin of Safety. Like Munger said, having "double layering protection against risk."
• "Stability is Unstable"!

Comments

[Bharper:]

This was in Berkshire's 2002 Annual report...it was part of Buffett's thoughts on "financial weapons of mass destruction". It describes to a T what happened to AIG:

"Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a
company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their
requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown."

2008 Sep 17 10:07 AM

[etrader:]

Buffett lost $2 billion in derivatives earlier this year- seems like a bit of a contradiction with this view.

2008 Sep 17 10:14 AM

[investor88:]

Good advice from Buffet, Charlie Munger and Jeremy Grantham about avoiding leverage. Except in some controlled situations, high leverage is toxic as the troubles besetting AIG, Bear Sterns, etc shows. A highly leveraged US government, consumer and financial institution is a recipe for disaster as the present crisis has demonstrated.

2008 Sep 17 10:24 AM

[captainccs:]

Buffett, Munger and Grantham are not talking the REAL cause of the current mess. The cause is the desire for safety and equal outcome. Everyone is entitled to a home, a job , medical care, etc, etc, etc. Your bank accounts are also protected by the government, you have the FDA to make sure all drugs are safe, you are paid millions for being stupid enough to spill hot coffee on yourself, if you are a banker you can discount your trash at the Fed, if you are a financial CEO your pay is not tied to results, you get a golden parachute no matter what and on and on and on.

Quite simply the necessary feedback mechanisms have been short circuited and the results should have been expected, an engine with no breaks on it, no governor, a loose cannon.

There is no free lunch.

2008 Sep 17 10:51 AM

[helplessobs...:]

Buffett cleaned up Gen Re's CDS positions after buying the company. This is where he learned his lessons on swaps. His paper loss now is on put options he wrote on the SP 500 due in 20 years, real long term leaps! We are in year eight of a secular bear market, with eight more years to go with the SP index range bound between 900 and 1500. This means by 2020 we will be in a new secular bull market and the puts he sold will expire worthless. In the mean time he will use his $4M premium to generate earnings for BRK shareholders.

2008 Sep 17 01:45 PM

[sleepy (lik...:]

I don't think 4 million is correct. Perhaps 4 bn.

2008 Sep 17 02:34 PM