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By Root 807 0

who got [the nation] into this mess”; then I gasped at the realization of what I had just said. For his part, Warren says that the documentation uses arcane language and that it is impossible to read that many prospectuses just to analyze one deal. One had to read “hundreds of thousands of pages.”20 Warren once noted: “There seems to be some perverse human characteristic that likes to make easy things difficult.”21 The simple solution boils down to the principles that Warren has espoused for decades: Don’t lend money to people who cannot pay you back. If you do not understand something, do not invest.

Chapter 7

Financial Astrology—AAA Falling Stars

I can’t recall we’ve ever asked for management changes in companies we’ve invested in. If they did the wrong thing, they should go.

—Warren Buffett,

Wall Street Journal, May 23, 2008

At the end of 2007, Berkshire Hathaway owned 48 million shares of Moody’s Corporation, one of the top three rating agencies (the same shares Berkshire owned when I first met Warren Buffett in 2005), representing just over 19 percent of the capital stock.The cost basis of the shares is $499 million. At the end of 2002, the value was just under $1 billion. By the end of 2006, the value was around $3.3 billion, but it dropped to $1.7 billion at the end of 2007.1 The sharp increase in revenues is due chiefly to revenues generated from rating structured financial products, and the sharp decrease was due to the disillusionment of the market with the integrity of the ratings.

The collateralized debt obligation market grew from around $275 billion in 2000, to about $2 trillion in 2007; then the market stalled. By June 11, 2008, Total Securitization reported that CDOs in default exceeded $200 billion.2 Investors included insurance companies, bank investment portfolios, mutual funds, pension funds, hedge funds, money mangers, and more. Every sector of society is affected as misrated products cause actual principal losses combined with loss in value due to declining market prices and illiquidity. More than that, liquidity—coming up with needed cash—is now a global problem, since investors are wary of lending money (by investing) against potentially misrated assets.

When I met Warren for the first time, I gave him a copy of another book that I had written, Collateralized Debt Obligations & Structured Finance (2003). It is a study of structured financial products in which I criticized holes so big in the rating agencies’ methodology that you can drive a semi through them. In particular, I highlighted serious problems with inflated AAA ratings in securitizations that have inherent structural flaws, problems with supposedly investment grade rated collateral, and conflicts of interest that hold investors’ capital hostage to the self-interest of “managers” and investment banks. Those conflicts of interest often result in substantial principal losses to investors, and the risk is not captured in the ratings. Cash flows held hostage to managers’ conflicts of interest result in investment casualties.

Investors should act like the Israeli Defense Force when rescuing hostages taken in an airplane hijacking to Entebbe—move fast, minimize hostage casualties, and never let it happen again. Unfortunately, instead of taking measures to correct these flaws, the rating agencies seemed to brush aside my concerns and ramped up their flawed structured products ratings business.

As Warren points out, everyone makes mistakes. I have found that most people will forgive you anything if there was no evil intent.You acknowledge the error and apologize, correct the error, if possible, and make a commitment to change. Forgiveness comes easier if you did not—inadvertently or otherwise—cause them to lose a pile of money, or harm their children by, say, losing a pile of money intended for their benefit.This works as well in finance as it does in daily life.

The rating agencies seem not to care about the market’s forgiveness since not only have they not apologized—a necessary, but not a sufficient condition—they seem