What Warren Said - Part 2 (Albo's dilemma)

This week we continue Buffett's response to the GFC inquiry. I have highlighted the important bits. 

Buffett: But, you know, Freddie Mac, Fannie Mae, they all felt different in the middle of 2007 than they did in the middle of 2006 or 2005, so…

Mr. BONDI: Uh-huh.

BUFFETT: People were watching a movie and they thought the movie had a happy ending; and all of a sudden, the events on the screen started telling them something different. And different people in the audience picked it up at maybe different hours, different days, different weeks. But at some point, the bubble popped and it, for different people, they were seeing it at slightly different times.

Mr. BONDI: What do you think it was, if you were to point to one of the single driving causes behind this bubble? What would you say?

BUFFETT: Well, there’s a very interesting aspect of this, which will take a minute or two to explain; but what my former boss, Ben Graham, made an observation, 50 or so years ago to me that it really stuck in my mind and now I’ve seen evidence of it. He said, “You can get in a whole lot more trouble in investing with a sound premise than with a false premise.”

So after a while, the original premise, which becomes sort of the impetus for what later turns out to be a bubble is forgotten and the price action takes over. Now, we saw the same thing in housing. It’s a totally sound premise that houses will become worth more over time because the dollar becomes worth less. It isn’t because — you know, construction costs go up. So, it isn’t because houses are so wonderful, it’s because the dollar becomes worth less, and that a house that was bought 40 years ago is worth more today than it was then. And since 66 or 67 percent of the people want to own their own home and because you can borrow money on it and you’re dreaming of buying a home, if you really believe that houses are going to go up in value, you buy one as soon as you can. And that’s a very sound premise. It’s related, of course, though, to houses selling at something like replacement price and not far outstripping inflation.

So this sound premise that it’s a good idea to buy a house this year because it’s probably going to cost more next year and you’re going to want a home, and the fact that you can finance it gets distorted over time if housing prices are going up 10 percent a year and inflation is a couple percent a year. Soon the price action -– or at some point the price action takes over, and you want to buy three houses and five houses and you want to buy it with nothing down and you want to agree to payments that you can’t make and all of that sort of thing, because it doesn’t make any difference: It’s going to be worth more next year.

And lender feels the same way. It really doesn’t make a difference if it’s a liar’s loan or you know what I mean? [Unintelligible] something because even if they have to take it over, it’s going to be worth more next year.

And the price action becomes so important to people that it takes over the -– it takes over their minds, and because housing was the largest single asset, around $22 trillion or something like that, not above household wealth of $50 trillion or $60 trillion or something like that in the United States. Such a huge asset. So understandable to the public -– they might not understand stocks, they might not understand tulip bulbs, but they understood houses and they wanted to buy one anyway and the financing, and you could leverage up to the sky, it created a bubble like we’ve never seen.

Mr. BONDI: Uh-huh.

BUFFETT: And I wish I had figured that out in 2005.

Mr. BONDI: The –- this bubble, though, has been described as different from prior housing bubbles and certainly the forces that you’ve described about prices and certainly the types of loans that you’ve described have been around for a while. What do you think, though, made this particular housing bubble different and what would you point to, to the growth of this particular housing bubble?

Some have pointed to cheap money, in essence. Some have pointed to lack of regulation in the origination business. Some have pointed to the drive from Wall Street for securitized mortgages and RMBS and then as collateral for CDOs. Others have pointed to government policy that created the housing bubble.

What do you think created and caused this housing bubble?

BUFFETT: That’s a great question to which I don’t have a great answer.

Why did the –- I read that the tulip bulb was in 1610 or 1620, but tulips had been around before, and they always looked beautiful, and people wanted them on their tables and all that. For some reason, it gets to a critical mass, a critical point is that where the price action alone starts dominating people’s minds.                And when your neighbor has made a lot of money by buying Internet stocks; and your wife says that “You’re smarter than he is and he’s richer than you are, so why aren’t you doing it?” When that gets to a point –- when day trading gets going, all that sort of thing, it’s very hard to point to what does it.

When people think there’s easy money available, they are not ‑‑ they’re not inclined to change.

Particularly if somebody said a month or two ago, “Watch out for this easy money,” and then their neighbors made some more money in the ensuing month or two, it’s just ‑‑ it’s overwhelming. And we’ve seen it.

Mr. Buffett: Well, there was a failure of everybody, in one sense. But the biggest failure is that they were unable to act contrary to the way humans act in these situations. I mean, you could say regulation about their screaming about the fact you people are doing foolish things. And, sure, regulators could have stopped it. If the regulators said ‑‑ or Congress could have stopped it ‑‑ Freddie and Fannie. If Freddie and Fannie had said, you know, “We will only accept mortgages with 30 percent down payments, verified income, and the payments can’t be more than 30 percent of your income,” you know, that would have stopped it. But, you know, who can do that?

I don’t think the President of the United States could have stopped it by rhetoric. And I think any President of the United States had said, you know, “I am campaigning on a program of 30 percent down payments, verified income, and not more than 30…,” they might not have impeached him, but they sure as hell wouldn’t have reelected him.

Read the last paragraph again. And now think about what position Albanese is in.