Buffet's Comments in BRK's 2008 Annual Report

Warren Buffet’s letter to Berkshire Hathaway shareholders in the BRK annual report contains a remarkable amount of plain-language information on the financial meltdown and how it will affect the economy in the future.
I heard about the report from an IEEE article, which does a great job summarizing Buffet’s letter.

Here is a passage I liked: (emphasis added)

This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation. Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly.

It goes on to explain how one Berkshire Hathaway subsidiary made good loans and is not in direct trouble, except for the fact it is now competing with politically-connected companies being rescued and subsidized by the government.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.”
[snip]
At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

Supporters of aggressive bailout measures tell us to understand that the money is not aimed at the deserving. It’s aimed at stabilizing the economy. If this situation of political connections determining business success goes on for long, it will hurt long-term growth. Before that happens, though, there will probably be a backlash. For believers in aggressive bailouts and stimuli, the measures had better work quickly before the backlash becomes widespread.

Populist Backlash Will be Against China and Inflation, Not Taxes

I've been hearing talk of a populist backlash against some of bailout measures started by President Bush and now carried on by President Obama. I would welcome a non-partisan backlash against growing government and deficit spending, but I don’t believe we'll see one. If we do have a backlash, it will be in the following areas:

• A nationalist backlash against US dependence on China – Lately they've been expressing concern about our loose monetary policy. Regardless of whether people agree with US monetary policy (or even know what monetary policy is), they might get tired of having to answer to China
• A backlash if inflation occurs – People remember the recessions of '02 and '91 more clearly than the inflation of the 70s. Inflation isn't all that bad, but since it's new it might seem scarier than a recession without inflation, which is fresher in people's minds. The higher nominal rates that come with inflation might make the housing bust more painful, as rising interest rates depress real estate prices.

If we push the fiscal and monetary stimuli levers too far, we will have these conditions and the political firestorm that comes with them.

US is Behind in Reducing Car Usage

Check out this post on Krugman's blog showing the popularity of various transportation means in various industrialized countries.



It's a shame how US is behind so many industrialized countries in reducing car usage. Part of it is urban planning, but a big part of it is habit.

I wonder how much better Madison is than the US average.

There's a 50% chance the world will have to adapt to using less energy, including fewer cars. There's a 50% chance someone will develop a way to transfer nuclear power into portable high energy density storage vehicle and capture any carbon that results when the energy is released. The latter is a hard order, but people really love the perceived freedom of single-person motorized vehicles. Habits are hard to break.

The Real Estate Bust Continues

From the Wall Street Journal: Yale’s Shiller: U.S. Housing Slump May Exceed Great Depression

Yale University economist Robert Shiller, pioneer of Standard & Poor’s/Case-Shiller home-price index, said there’s a good chance housing prices will fall further than the 30% drop in the historic depression of the 1930s. Home prices nationwide already have dropped 15% since their peak in 2006, he said.

Some people think that because real estate prices have fallen it means that the bust is over. It certainly is not. For it to be over, prices have to return to parity with rents. We are moving in that direction but are not there yet. I suspect the value/rent ratio will overshoot below historical averages just as it overshoot above averages on the way up.

In addition to the value/rent ratio decreasing, rents are depressed by the increase in housing units without a corresponding increase in people needing housing.

Two other factors complicate the real estate market

• There are ghost neighborhoods of empty housing units all in the same area. Their existence may affect the market more than the same number of empty units mixed randomly with occupied housing.
• In some states the laws prevent banks from collecting the deficit balance if a foreclosed house does not cover the loan. There has been a lot of speculation, often self-serving speculation on the part of people who made the loans, that could cause large numbers of foreclosures among people who are fully capable of paying their bills.

My prediction continues to be that the Fed will pursue a loose monetary policy leading to inflation. Real (i.e. inflation adjusted) rents will decline slightly while real property values plummet. The inflation will mask this situation and make it seem (to people not considering inflation) like rents are going up and property values are stagnant. This situation will continue for several years until rent and property prices are at their historical parity.

Inflation hurts bondholders, but it won't hurt holders of mortgage backed bonds very much, because the value of their bonds decreased along with the value of the real estate collateralizing them.

But what about the Treasury? It's yield is low thanks to a flight to quality. If my inflation prediction holds true, however, we might see the Treasury yield rise significantly.

The politicians running for president are calling for new programs and no new taxes on the middle class. If borrowing becomes more expensive, that won't be an option.

Environmentalism Is Not at Odds with Individualism

This past week at church and on Wisconsin Public Radio I have heard criticism of excessive individualism as part of the discussion of Earth Day.

I understand where this is coming from, but we should be cautious about thinking of individualism as being at odds with environmentalism. Individualism is necessary, IMHO, for a pleasant life in a densely-populated, environmentally-friendly community.

We need to be aware of how our activities affect other individuals and not expect to be able to do things that cost other people without paying damages.

In the past damage to the environment was easy to see: Emission from your activities caused direct irritation to people nearby. Global climate change is much harder to see. We're not even sure how much of it is due to human activities. (We know human activities are a significant part of it.)

Global warming will be harder to address than previous environmental issues because the very foundation of the world economy, fossil fuels, is the main cause. It's a problem whose impact could be as serious as World War II, and the solution will require completely modifying the world economy, just like WWII.

I am optimistic, though, that people are becoming aware of the problem and willing to make big changes. No one technology or behavioral change will solve the problem. Many small steps, though, will solve the problem.

Masking the Real Estate Bust Using Inflation

The American Enterprise Institute in an editorial in yesterday's Wall Street Journal calls for expanding the money supply and ignoring the resulting inflation: The Inflation Solution to the Housing Mess

The least bad option is for the Federal Reserve to print money to help stabilize housing prices and financial markets. Yes, use reflation to soften the pain for Main Street and Wall Street. If instead we let housing prices fall another 25%-30% – as predicted by the Case-Shiller Home Price Index – it's almost certain that Washington will end up nationalizing the mortgage business.

I predicted over a year ago (unfortunately before this blog's existence) that this would happen. Lowering rates without regard to inflation has already been the Fed's policy since the housing bust started in earnest.

It's surprising to hear calls for loose monetary policy from a rightwing source. The article says they would rather accept inflation now, though, than deal with excessive action from Congress, which would be harder to undo than a monetary policy decision.

The Fed will allow inflation to happen, not because of rightwing fear of regulation, but because there are quite a few highly leveraged homedebtors who stand to benefit.

The article doesn't mention two other repercussions from the higher nominal interest rates that come with inflation:

• There will be increased pressure to balance the federal budget.
• Higher mortgage rates will intensify that effect of falling inflation-adjusted real estate prices.

These things aren't horrible. They're side effects of over-medication of the economy. This over-medication is a response to living on the economic edge, i.e. excessive risk taking and insufficient savings.

The right thing is for the Fed and Congress to act moderately. The economy is a problem primarily for people who took big risks. Risk takers getting hurt once in a while is supposed to be part of an economic system.

Predicing the Real Estate Bust and Transferring Risk

There is a good story on Calculate Risk on predicting how long it will take the housing bubble to deflate. If it follows that path of the LA housing bust in the early 90s, it will mostly deflate by 2010 and bottom out in 2013.

This is interesting, but market risk shouldn't matter too much to families buying a residence if the property costs less than the family's net worth.

Consider a family with a net worth of $300k in a $200k house. If real estate falls 15%, their house is worth $170k. They have lost 10% of their net worth. The costs of owning a home (insurance, taxes, maintenance, interest) predominate over movement in housing costs.

By contrast, if their net worth had started out at $30k, the change in housing prices would have wiped them out.

Both the $300k and $30k families should weigh the costs of ownership vs. the cost of renting and, all things being equal, should take the lower cost choice. The difference is the $300k family can afford to accept more risk. The $30k family might forgo owning a home even if it were the less expensive choice if they feel they cannot accept the risk of market fluctuations wiping them out. If they rent, their landlord is making a profit for taking the risk off of the family.

This payment for risk transfer is similar to insurance. Poor people pay for towing insurance on their auto policy until they save up enough money that they can easily handle the costs if their car should need to be towed. Similarly, people increase the deductibles on all their insurance policies as their reserves of emergency cash increase.

Poor people end up paying the rich to carry risk for them. Is this unfair? Should the economic system be changed to reward those who do work rather than those who take financial risk? These questions are way beyond the scope of this post.

The point is people should calculate how much risk their taking versus the benefit they're getting for taking the risk.

In my area this is a moot point when it comes to housing because the costs of renting a home are less than or equal to the cost of owning one. As the bubble deflates (probably in the form of nominal rents rising faster than nominal property values) and it becomes profitable again to be a landlord, people will have to ask if lower property costs are worth the market risk.

Financial Predictions for 2008

The housing bubble is far from finished deflating. The Fed will keep short-term rates low to prevent the bust from spreading to other areas of the economy. This will be successful and prevent consecutive quarters of GDP contraction (i.e recession).

Nothing can change the fact that more housing units were created during the boom than people to fill them, so inflation-adjusted real estate prices will continue to decline. The lower short-term rates may slow the decline slightly by providing low payments on adjustable loans. This effect will be limited, however, by underwriting guidelines that require borrowers be able to pay potentially higher payments if their loan adjusts upward.

A side-effect of the lower interest rates will be increased inflation. We are already seeing this now. The trend will continue for 2008 and beyond. This will hurt long-term bond holders and help homedebtors by masking the decline in their houses' prices.

Oil prices will decline due to a) a decrease in global GDP growth, b) increased oil exploration funded by higher oil prices, and c) increased interest in conservation and renewable energy.

Increased inflation may lead to higher yields on Treasury bills and the US Dollar declining further against the Euro. A declining dollar may decrease the US trade deficit. Higher yields on Treasury bills will force the US government to decrease its expenses and/or increase taxes. This guns or butter pressure will be favorable to Democrats, who are perceived as stronger on domestic issues. Demagoguery about the threat of international terrorist networks will decrease. A decreased trade deficit may ease the pain of increased global trade, but globalization is slowly transforming the world in a huge way. This transformation will continue for decades to come. Expect demagoguery on this issue.

In rising inflation environments, gold and basic materials tend to rise. This effect on gold, however, may be offset by how much gold has already risen in recent times and by a lack of truly negative economic news in 2008. Increases in basic materials may be offset by a slowing in global GDP growth. As a result gold and materials will not be a reliable hedge against inflation.

Healthcare will be a good investment sector because it tends to do well in an inflationary environment and because of an aging population. Market reforms in healthcare will be good for consumers and the investment sector, if healthcare providers can learn to provide better customer service. If they cannot, there may be a backlash resulting in a national healthcare plan. The effect of such a plan depends on the details and cannot be predicted at this point.

Consumer staples and utilities will do well due in 2008 to inflation without a significant recession.

There is a chance for nanotechnology, biotechnology, or alternative energy to do well because of possible and breakthroughs and because of the possibility of speculative fervor developing around one of these sectors.

Instruments that benefit from a rising Treasury yield will do well because yields are near their historic lows and rising inflation will drive it up.

The US stock market will perform lower than average in 2008 because of inflation concerns, but it will do well in coming years because the fundamentals of the US economy are strong. Inflation and the ongoing real estate bust will be something for journalists to write about over the next year or two but are not at all threats to foundation of the economy.

Note: This post represents my guesses. I have no formal training in finance. Nothing I say is intended as financial advice. Even if I were formally trained in finance, people need to consider their individual situation before making investment decisions.

The Decline of the Nation State

Earlier this year I talked to two people who told me that globalization is shaking up US society because corrupt politicians just look the other way. All of the negative affects of liberalized trade, they said, could be prevented by the government acting in the interests of ordinary citizens rather than those of corporations.

While it's true that large special interests must get something for their political contributions, I don't think poor policy making explains the negative effects of globalization.

Technology has shaken up everything, and there's nothing that can turn it back, at least not if we're interested in continuing to have heaps of consumer products. We're falling into history. A future history book might have a chapter titled, "The 21st Century: The Decline of the Nation State". That's bigger than any crooked politicians. After 30 centuries, the nation state is the devil we know. Thanks to cheap energy and telecommunications, we're just starting to try something new.