Lose money for the firm, and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.
– Warren Buffett (1991)
I’ve never been in Moody’s. I don’t even know where they’re located.
– Warren Buffett (largest Moody’s shareholder, 6/3/2010)
My idol Warren Buffett died yesterday. Not the man; he is alive and well (although he does look like he has aged severely over the past year). What died was my idealized version of him. On Thursday, Buffett appeared before the Financial Crisis Inquiry Commission (FCIC), the non-partisan body established in May 2009 to investigate the causes of the 2008-09 financial meltdown.
He did not appear willingly. In fact, when first invited, he said no. The only reason he appeared was because he was subpoenaed. This is not the Buffett I know. I’ve always thought that Buffett was civic-minded. After all, he has spoken out on public issues before, including his support of the estate tax and higher tax rates for the rich. Yet, when called by his country to testify and help the American people understand the cause of the financial crisis that has knocked so many people into debilitating unemployment, he couldn’t voluntarily find the time. Shame.
Back in April, I wrote about my admiration of Mr. Buffett. Of course, he is extremely wealthy and is a great stock picker, having compounded shareholder wealth at an annual rate of 22% for 45 years. But what set him apart from other multi-billionaires was his “good guy” image, the rock-star, ukulele-strumming grandpa at Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) annual meetings who loved to answer shareholder questions for six hours straight. As evidenced by the introductory quotation above, he also was instrumental in getting Salomon Brothers back on track in 1991 after a bond trading scandal almost brought down the firm.
Defending the Indefensible Goldman
His image with me actually started to crumble before yesterday’s testimony at the FCIC hearing. Back in May at the
Based on Buffett’s earlier cleanup of Salomon Brothers’ ethical problems in 1991, I expected him to similarly scold Goldman. But no, Buffett insisted that Goldman had done nothing wrong! He said that an investment bank was expected to act like a carny (i.e., carnival showman) that profits from deceiving customers. Umm… no it’s not,
Goldman pays us $500 million a year in annual dividends. $15 a second. Tick, tick, tick. I don’t want those ticks to go away. They pay me at night, on weekends… We love the investment.
There you have it. Buffett wouldn’t criticize Goldman because he is making too much money to care.
Buffett’s Debacle Before the FCIC
That was bad enough, but Buffett’s testimony yesterday at the FCIC hearing regarding Moody’s (NYSE: MCO), a credit rating agency at the heart of the financial crisis, broke the camel’s back concerning my opinion of him. First, Buffett refused to provide the commission with any written testimony, the only one not to do so. Second, Buffett acted uninformed and, even worse, indifferent and evasive to the commissioners’ questions.
Defending the Indefensible Moody’s
When FCIC Chairman Phil Angelides asked Buffett if the leadership of Moody’s bears responsibility for the faulty ratings that allowed subprime mortgages to be rated triple A, Buffett said no. He said that only hedge fund managers John Paulson and Michael Burry figured out back in 2005-2006 that the housing bubble was about to burst and that Moody’s management “made the same mistake that 300 million Americans made.” Buffett said there was no historical precedent for home prices falling nationwide and that Moody’s had no reason to tweak its default models in expectation that such a price drop would occur.
This argument is plain silly. As former Moody’s compliance chief Scott McCleskey said after the hearing:
The excuse that the rating agencies simply misjudged the housing bubble like everyone else misses the point — they weren’t just like everyone. The market and the public looked to the rating agencies to have a deep and well-informed look at the market. They were the ones who were supposed to tell everyone else it was a bubble.
Chairman Angelides also did not like Buffett’s whitewash of Moody’s culpability, saying that there were plenty of “red and yellow flashing lights along the way” concerning the impending housing market collapse. He held up the cover of a June 18th, 2005 issue of the Economist magazine entitled “After the Fall,” which referred to the scary economic consequences that a fall in home prices would cause. The article stated that the current housing boom was:
by far the biggest boom in American history, with real gains more than three times bigger than in previous housing booms in the 1970s or the 1980s.
Although previous housing booms had not resulted in home prices dropping, but simply stagnating for a prolonged period as inflation reduced their real value, this boom was sufficiently different that an actual drop in home prices should be expected.
What was Buffett’s response? He quipped that the Economist only wrote the article in hindsight after the collapse and failed to foresee the collapse by writing an article entitled “Before the Fall.” Oh boy. How embarrassing for the sage of
Angelides then mentioned that two senior executives at Moody’s claimed that they had complained to Buffett early on that there were problems with Moody’s ratings. Buffett categorically denied ever receiving such complaints (basically calling the Moody’s executives liars). But one of the Moody’s executives said after the hearing that he has evidence: “I reached out to him, and I’ve got the e-mail sent to him and the commission has it as well.” The McClatchey newspaper has verified the executive’s story. Buffett is so busted.
Holtz-Eakin is My Hero
My favorite part of the hearing was when it was Douglas Holtz-Eakin’s turn to ask questions. You couldn’t help but notice that Holtz-Eakin was the smartest guy in the room. Whereas the other FCIC commissioners acted deferential toward Buffett, Holtz-Eakin was unfazed and went right after him. If you recall, Holtz-Eakin was a former director of the Congressional Budget Office (CBO) during the George W. Bush administration. He also wrote that scathing New York Times op-ed on the runaway costs of Obama’s healthcare reform legislation which I cited in my article entitled The $700 billion Lie.
Anyway, around the 1:43:00 mark of the video, Holtz-Eakin asked Buffett about his status as Moody’s largest shareholder. Since Buffett is a long-term investor, didn’t he think that Moody’s faulty ratings impacted the long-term value of Moody’s shares? Buffett replied that he had bought Moody’s stock because of the low-competition, duopoly structure of the credit ratings industry (Moody’s and Standard & Poor’s control the market), which gave Moody’s abnormal pricing power. Holtz-Eakin seized on this response, following up by asking Buffett: “So you bought Moody’s stock because of its duopoly market position and not because it had quality ratings?”
Buffett answered yes. He admitted that he did not have a good grasp of Moody’s internal controls or analytical ability to evaluate credit risks. Among the admissions I heard Buffett make:
“I have no idea about their due diligence”
“I don’t know about the internal controls at Moody’s”
“I’ve never been in Moody’s. I don’t even know where they’re located.”
“Am I going to investigate? No.”
Buffett justified his ignorance by saying that he had no reason to doubt the integrity of Moody’s credit ratings. That answer was too much for Chairman Angelides. He asked Buffett if he was aware of two investigative reports from the SEC, one from 2003 (p. 41) and one from 2008 (p. 23), both of which concluded that the way credit rating agencies were compensated for setting their ratings (i.e., issuer pays) created a significant conflict of interest. Buffett replied that he had never read either report!
I couldn’t believe my ears. Here is one of the greatest investors of all time admitting that he had become Moody’s largest shareholder without knowing anything about the company’s business integrity or ratings quality. All he knew was that the company was highly profitable and could gouge the issuers it rated with anti-competitive monopoly-like pricing.
Corruption at Moody’s Was Rampant and Widespread
In fact, the integrity of Moody’s credit ratings has been severely compromised since at least 2006. Incriminating emails from employees of both S&P and Moody’s have been released that say things like:
1. “Let’s hope we are all wealthy and retired by the time this house of cards falters.”
2. “It seems to me that we had blinders on and never questioned the information we were given. These errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue.”
Eric Kolchinsky, former head of Moody’s sub-prime mortgage rating business, submitted written testimony to the commission prior to Buffett’s appearance in which he had stated:
The rating agencies faced the age old and pedestrian conflict between long term product quality and short term profits. They chose the latter. For senior management, concern about credit quality took a back seat to market share. While there was never any explicit directive to lower credit standards, every missed deal had to be explained and defended. Contrary to the testimony of a Moody’s senior director, banker requests to keep certain analysts off of their deals were granted.
Kolchinsky also testified that Brian Clarkson, former President of Moody’s, had demoted him as punishment for questioning the high ratings being assigned to sub-prime bonds. Kolchinsky was not the only victim of Clarkson. According to written testimony of former Moody’s Vice President Mark Froeba:
Moody’s primary tool for implementing the culture change was a person not a technique, Brian Clarkson. In this task, Brian was especially adept at threats of employment termination. I have heard Brian conjugate the verb “to fire” in moods and tenses most grammarians do not even know exist. In my ten years at Moody’s, I do not think I had three consecutive encounters with Brian in which he did not threaten to fire someone, describe someone he had fired or identify someone he should have fired.
Clarkson was scheduled to appear at yesterday’s FCIC hearing on the same panel with Froeba, but at the last moment cancelled because of a “medical emergency” involving an alleged kidney stone. That excuse would be funny if the subject matter of the hearings wasn’t so serious. I hope the commission subpoenas Clarkson to appear later and respond in person to Kolchinsky and Froeba’s accusations.
Disappointment With Buffett
It’s hard to believe that Buffett – Moody’s largest shareholder — knew nothing about the corruption inside of Moody’s. In fact, he didn’t seem to care. All he cared about was that Moody’s was a virtual monopoly making money hand over fist. After the hearings, Chairman Angelides voiced his disappointment with Buffett’s testimony, saying: “I’m not sure he fully comprehends the range of questions raised about Moody’s business practices and culture.”
That’s an understatement.
Rest in peace, Warren Buffett’s reputation. I miss you.
My idealized admiration for
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