Tag Archives: congress

Buffett Explains Bubbles

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

3 Things I Think I Think – Financial Crisis Edition

Here are some things I think I am thinking about: Warren Buffett on the financial crisis, investing with a sound premise & silly Congressional ideas. 1 – What Caused the Financial Crisis according to Warren Buffett? The National Archives released documents related to the Financial Crisis late last week. Among them were some interviews with Warren Buffett on the crisis. I noticed that, aside from being nerdy white guys, the only thing I might have in common with Buffett is that we both believe the cause of the financial crisis was, well, just about everybody: I think the primary cause was an almost universal belief, among everybody ‑ and I don’t ascribe particular blame to any part of it – whether it’s Congress, media, regulators, homeowners, mortgage bankers, Wall Street ‑ everybody ‑ that houses prices would go up. ” I’ve described this several times over the last 7 years and every time I do it, I seem to catch a bunch of flak from people with a political bone to pick. And every time I see someone trying to place sole blame on “the government” or “Wall Street” or “house flippers” or whoever, I am reminded of how common fallacies of composition are in the financial world. We don’t see things in totality. We see what we want to see inside of the big picture so we can confirm what we already believe. This just leads to a lot of narrow-minded thinking that causes more arguments than objective analysis. 2 – Investing with a False Premise. One comment I disagreed with (at least partly) was Buffett quoting Ben Graham on investing with a false premise: ” You can get in a whole lot more trouble in investing with a sound premise than with a false premise .” I don’t know about that. If you’ve read my paper on the monetary system or portfolio construction , you’ve probably noticed that this is the primary thing I am trying to avoid when analyzing the economy – false premises. There are so many myths and misconceptions about money that you can get into a lot of trouble buying into these ideas. Whether it’s flawed concepts like the money multiplier, crowding out, being a permabull/bear, dividend investing for safe income, “beat the market” or whatever. Starting with a sound premise is an intelligent way to improve the odds that you’ll succeed going forward. Of course, you have to maintain some rationality within this context. Extremists get killed in the financial markets because they tend to go all in on what they believe. Believing that house prices never go down was obviously irrational (and I had that argument with a lot of people back in 2005/6), but the fact that asset prices usually go up is not an unsound premise from which to start because the economy usually expands and people tend to become more productive over time. So, in this example, being a rational optimist always beats being a perma pessimist AND a perma optimist. 3 – Let’s talk about that silly balanced budget idea. One myth that just never dies is this idea that the US government is going bankrupt and needs to tighten its belt so we avoid impending crisis. I’ve spent an inordinate amount of time debunking this myth over the last decade, but I wanted to congratulate a group of economists for fighting back against a truly stupid idea – a federal balanced budget amendment. Mark Thoma linked to this letter yesterday highlighting the dangers of a balanced budget amendment. I’ll just point out two facts: First, one of the most powerful economic policies we have in place is what’s called automatic stabilizers. This is the tendency for the budget deficit/surplus to expand and contract naturally to offset economic conditions. So, during a recession, government deficits rise because spending naturally increases due to things like unemployment benefits while tax receipts decline. This leads to more income to the private sector and a flow of net financial assets that helps offset the decline. And the exact opposite happens during booms thereby cushioning against the risk of booms. If we had a balanced budget amendment in place, the economy would likely be a lot more volatile because these stabilizers would be gone. Second, the federal government plays an important role in ensuring that our states don’t turn into Greece. As I’ve explained before , since the states have balanced budget amendments, they are constrained by a true solvency constraint. The states, like Greece, have real limits on how much debt they can issue. But since the US states run trade surpluses/deficits against one another with no foreign exchange rebalancing then the poor states are always exporting more dollars than they’re importing. They can borrow to offset this, but there’s a Congressionally mandated limit to this borrowing. So, where does the income come from that helps avoid inevitable insolvency and occasional financial crisis? You guessed it – it comes from the federal government who takes more from the rich states and redistributes it to the poor states. It sounds like socialism, but it’s actually saving capitalism from itself. And it works beautifully in the case of a single currency system by helping us avoid the debacle of a situation that is Europe….