Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [68]
The rating agency business will probably pull in steady business in the future because the market has nothing to replace them. That does not mean, however, that the market is satisfied with the cartel’s performance. Warren Buffett avoids interfering with the management of the companies with which he invests but he made an unprecedented statement during his European excursion to find new investments. In May 2008, he said if Moody’s management did something wrong, “they should go.”32 Weeks earlier, Warren told me he is “not proud” of Moody’s. One could say the same for Standard & Poor’s and Fitch. Misleading ratings contributed to the global market meltdown, because many financial institutions used “high” ratings as a sign of “safety” to justify their use of excessive leverage.
Chapter 8
Bear Market (I’d Like a Review of the Bidding)
It’s easy to put on leverage, but not as easy to take it off.
—Warren Buffett
(Wall Street Journal, April 30, 2007)
In 2007, both Warren and I thought many hedge funds were overleveraged. If the book value of Berkshire Hathaway stock falls 5 percent, investors have “lost” 5 percent for the moment, but Berkshire Hathaway’s strong earning power (from subsidiaries and investments) will likely cause the price to rise satisfactorily again in the future. Berkshire Hathaway has value and its value is growing.A leveraged hedge fund that invests in collateralized debt obligations (CDOs) can only rely on those CDOs for “earnings.” If the CDOs deteriorate due to, say, defaults on the loans backing them, there is permanent value destruction. There is no bouncing back from that. Furthermore, leverage magnifies the losses for investors. Bear Stearns Asset Management managed two hedge funds that provided classic examples.
On January 30, 2007, Jim Melcher of Balestra Capital (a $100 million hedge fund) and I appeared on CNBC to discuss hidden price deterioration in subprime CDOs. Diana Olick, CNBC’s Washington-based real estate correspondent taped the segment. Olick may be the best reporter on any channel on this topic; she closely followed developments before the mortgage meltdown was big news. She reported that housing prices were softening and had risen only 1 percent the previous year for existing homes against the double-digit increases of the prior few years. Subprime mortgage loans had reached around $1.3 trillion in outstanding loans of the total $11 trillion (at the time) U.S. mortgage market. The foreclosure rate was already 13 percent (in the years before the 2005 risky loan explosion delinquency rates were in the low to mid-single digits) and climbing fast and steeply for more recent (2006) vintages.
Based on my projections, foreclosure rates for subprime loans made in 2006 could reach 30 percent and recovery rates would probably be only around 30 cents on the dollar. This was based on my experience during other times of severe mortgage loan stress combined with poor underwriting standards. This meant that recent subprime loan securitizations were in trouble. Most investment-grade-rated residential mortgage-backed securities were in serious trouble at the lower levels, and the AAA tranches did not have enough protection to merit that rating. CDOs compounded the problem and CDO-squared products amplified it further. For those deals, even the AAA tranches had significant risk of substantial losses.
I told Olick that investors who bought non-Fannie Mae and non-Freddie Mac securitizations should be very worried. Deals were overrated and overpriced, and prices would plummet. Jim Melcher was short the ABX index, the ABX HE 2 06 BBB- series, to profit on overrated and overpriced subprime-backed CDOs. He had tripled his money the prior two months and was one of the few hedge fund managers