Buffett Explains Bubbles

By | March 18, 2016

Scalper1 News

Back when the financial crisis was in full blown collapse mode, the government stepped in to shore up the problem areas and infused a huge amount of reassurance in the financial system. It was like a giant hug for the markets, for the people, and anyone else that needed one, that said, “things will be okay.” Then the government did what all governments do best. Congress formed a committee to investigate why it happened. They needed a villain. So the FCIC, Financial Crisis Inquiry Committee, was created to find who or what was to blame. In the end, we all know what happened. The banks took the heat while a lot of the co-conspirators walked away clean. In reality, it was a fairly solid team effort between lenders, borrowers, Congress, rating agencies, regulators, Fannie Mae ( OTCQB:FNMA ), Freddie Mac ( OTCQB:FMCC ), mortgage brokers, real estate speculators, derivatives, media, etc. that led to the largest bubble and crisis in history. This past weekend, the FCIC made available some transcripts and notes from that investigation. One of those transcripts was a two-hour interview with Warren Buffett. I won’t cover the entire interview though it was an interesting read (at least I thought so). Buffett offered an enlightening take on bubbles, which I thought I’d share. It didn’t cause it, but there were a vast number of things that contributed to it. The basic cause, you know, embedded in psychology – partly in psychology and party in reality in a growing and finally pervasive belief that house prices couldn’t go down and everyone succumbed – virtually everybody succumbed to that. But that’s – the only way you get a bubble is when basically a very high percentage of the population buys into the same originally sound premise and – it’s quite interesting how that develops – originally sound that becomes distorted as time passes and people forget the original sound premise and start focusing solely on the price action. So every – the media, investor, the mortgage bankers, the American public, me, my neighbor, rating agencies, Congress, you name it, people overwhelmingly came to believe that house prices could not fall significantly. And since it was the biggest asset class in the country and it was the easiest class to borrow against, it created probably the biggest bubble in our history. … I think every aspect of society contributed to it virtually, but they fell prey to the same delusion that existed throughout the country eventually and it meant that the models that they had were no good. They didn’t contemplate – but neither did the models in the minds of 300 million Americans contemplate – what was going to happen. … 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.” … 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 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…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. … It wasn’t like somebody was thinking, “This is going to end in a paralysis of the American economy.” You know, they just – they started believing what other people believed. It’s very tough to fight that. Of course, a similar sound premise was behind the ’29 bubble and internet boom. Buffett explained both cases started with a sound premise – stocks outperform bonds over time and the internet will change our lives – which was a solid argument for owning stocks. But at some point, the sound premise became “you should own stocks because prices are going up,” then momentum and FOMO (Fear Of Missing Out) kicked in. Eventually, people gradually wake up to the reality that it’s not true and the bubble pops. Source: Buffett FCIC Interview Transcript Scalper1 News

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