What Warren Said - Part 3

Let's continue with Buffett's evidence to the GFC Inquiry....

Buffett: Leverage was not as much a factor in a bubble. But I think in this particular bubble, because leverage is so much a part of real estate, that once you loosened up on that, you’ve provided fuel that caused that bubble to get even bigger, and you made the pop even bigger, when it finally did pop.

Mr. Seefer: Uh‑huh. Any views on the role of fraud, whether mortgage fraud or other types of fraud in the crisis?

Mr. Buffett: Well, I mean, there was, obviously, a lot of fraud. There was fraud on the parts of the borrowers and there was frauds on the part of the intermediaries, in some cases. But you’d better not have a system that is dependent on the absence of fraud. I mean, it will be with us. Oh, it had plenty to do with it. I mean, it fueled the ‑‑ it fueled extreme leverage, and it fueled leverage that could only be paid out of the resale of the asset rather than the income of the borrower.

Our Thoughts - this is why negative gearing can be a disaster for some. Losing money on purpose in the hope of a large capital gain works when it works, but when it doesn't the losses can be large. And consider that someone must hold every asset there will be losers. 

Buffett: Once you ‑‑ once you start lending money, big time, to people where your hope of getting your money back is that the asset goes up rather than the asset produces enough to service the loan, I mean, that’s very dangerous, whether it’s farmland, whether it was oil in Texas. It creates a lot of problems.

But I ‑‑ you know, when people talk about excess funds around the world and all that, I tend to discount that sort of thing. But I don’t discount the incentives of everybody in the American public from wanting to do a piece of business if they can do it tomorrow.

It doesn’t mean they’re terrible people or anything. But, you know, if I’m a realtor and I’ve seen a house go from 250,000 to 500,000, do I say to the person now, just buying the house at 500,000, “I really think this is kind of dumb because it’s only 250,000.” It just doesn’t happen.

They say, you know, “You’d better do it today because there’s going to be more tomorrow.”

And so everybody gets into the act. It doesn’t mean they’re evil people. There are some crooks in the process. But overall what happened was not caused by the crooks. It may have caused the crooks to get rich, and a lot of ‑‑ but it, in my view, was caused by a mass delusion.

Our Thoughts - we have spoken about this on the podcast. Incentives matter. But more importantly leverage can be a drug on the way up, but the downside is painful if you overreach as many do. There is always some fraud, but it is striking the amount of fraud that is discovered once you look hard enough. But if incentives mean we are all making money, then regulators tend not to look too hard. But they are forced to after the bubble bursts. It's then the regulator will blame many industry people without saying "maybe some of you just took too much risk and leverage". No politician encourages investors to blame themselves. 

But as Buffett says, once again it is a groupthink mentality combined with the idea of easy money.