Warren Buffett's 2008 Letter to Shareholders

“By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.”

Berkshire 2008

Publish at Scribd or explore others: Business & Legal Other report archaeology

John Paulson: Distressed Opportunities

From Bloomberg News:

Distressed assets offer the best investment opportunities this year as the global recession deepens, billionaire hedge-fund manager John Paulson said.

“The decline in the market has created a very good buying opportunity,” Paulson, 53, whose New York-based Paulson & Co. oversees about $30 billion, said in a speech at a hedge-fund seminar hosted by Societe Generale and Lyxor Asset Management in Tokyo today. “Distressed opportunity in the U.S. is shaping up to be the best opportunity in a lifetime.”

Paulson said he’s focused on assets such as mortgages and debt from bankrupt companies, while in the equities markets he cited the utilities, consumer staples and pharmaceutical industries. Financial stocks remain risky, Paulson said.

In the 15 years since starting its first funds, Paulson & Co.’s one down year was 1998. All his funds were profitable in 2008, with the flagship fund returning about 38 percent, compared with a loss of 19 percent for hedge funds worldwide on average. The 2008 returns came after his funds made more than $3 billion for the firm in 2007 by anticipating the collapse of the U.S. housing market and subprime mortgages.

Investors are chasing distressed assets after more than $1.1 trillion in losses at financial firms globally and frozen credit markets helped drag the U.S., Europe and Japan into their first simultaneous recessions since World War II.

Deep Recession

“In 2009, we expect this recession is going to be deeper and longer than consensus estimates,” Paulson said. “We don’t think we’re through the banking crisis yet. We think that in many cases, losses the banks will experience will exceed their common equities.”

Hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any assets, bet on falling as well as rising asset prices, and participate substantially in profits from money invested. Managers typically charge fees equal to 2 percent of client assets and 20 percent of investment profits.

“We’re bearish on the economy, but very bullish on opportunities in front of us,” Paulson said.

Merger Trainwrecks

It turns out that the Zell-Blackstone deal, as well as the Blackstone IPO, marked the exact top of their respective markets:

http://www.nytimes.com/2009/02/07/business/07properties.html?_r=1&em=&pagewanted=all

As a general rule, mega M&A deals always tend to mark the top of a market. We saw this in the 1980s with Merger Mania, culminating in the historic $30 billion RJR Nabisco LBO – right in front of the early 1990s recession.

We saw it in early 2000, with the $164 billion AOL-Time Warner deal, one of the greatest value-destroying transactions of all time. The merger agreement was filed in February of 2000, the market's apex. By 2002, the value of AOL was written down by $100 billion.

And, of course, the financials: MBNA and Bank of America in 2006; Bank of New York and Mellon in summer of 2007; and Bank of America buying Countrywide Financial in early 2008, to name a few.

However, the worst may be RBS and Fortis' colossal $100 billion acquisition of ABN AMRO in October of 2007 – again the exact top of the market. Fortis is now defunct and RBS is being propped up by the British government.

By contrast, heavy bankruptcies are a positive sign. And sharply-reduced capacity and inventories, especially when they have been depressed for long periods of time and demand appears to be improving, are signs of a market bottom.

This is probably where agriculture markets are right now. It continues to appear that agriculture may well enter a bull market over the next few years.

Agriculture Crisis

It looks as if agriculture futures might be in for a ride sooner than I had expected:

http://www.nytimes.com/2009/02/22/us/22mendota.html?hp=&pagewanted=all

Talk about an absolutely killer case of stagflation.

…

MENDOTA, Calif. — The country’s biggest agricultural engine, California’s sprawling Central Valley, is being battered by the recession like farmland most everywhere. But in an unlucky strike of nature, the downturn is being deepened by a severe drought that threatens to drive up joblessness, increase food prices and cripple farms and towns.

Across the valley, towns are already seeing some of the worst unemployment in the country, with rates three and four times the national average, as well as reported increases in all manner of social ills: drug use, excessive drinking and rises in hunger and domestic violence.

With fewer checks to cash, even check-cashing businesses have failed, as have thrift stores, ice cream parlors and hardware shops. The state has put the 2008 drought losses at more than $300 million, and economists predict that this year’s losses could swell past $2 billion, with as many as 80,000 jobs lost.

“People are saying, ‘Are you a third world country?’ ” said Robert Silva, the mayor of Mendota, which has a 35 percent unemployment rate, up from the more typical seasonal average of about 20 percent. “My community is dying on the vine.”

Even as rains have washed across some of the state this month, greening some arid rangeland, agriculture officials say the lack of rain and the prospect of minimal state and federal water supplies have already led many farmers to fallow fields and retreat into survival mode with low-maintenance and low-labor crops.

Last year, during the second year of the drought, more than 100,000 acres of the 4.7 million in the valley were left unplanted, and experts predict that number could soar to nearly 850,000 acres this year.

All of which could mean shorter supplies and higher prices in produce aisles — California is the nation’s biggest producer of tomatoes, almonds, avocados, grapes, artichokes, onions, lettuce, olives and dozens of other crops — and increased desperation for people like Agustin Martinez, a 20-year veteran of the fields who generally makes $8 an hour picking fruit and pruning.

“If I don’t have work, I don’t live,” said Mr. Martinez, a 39-year-old father of three who was waiting in a food line in Selma, southeast of Fresno. “And all the work is gone.”

In Mendota, the self-described cantaloupe center of the world, a walk through town reveals young men in cowboy hats loitering, awaiting the vans that take workers to the fields. None arrive.

The city’s main drag has a few quiet businesses — a boxing gym, a liquor store — and tellingly, two busy pool halls. The owner of one hall, Joseph R. Riofrio, said that his family had also long owned a grocery and check-cashing business in town, but that he had just converted to renting movies, figuring that people would rather stay at home in hard times.

“We’re not going to give up,” Mr. Riofrio said. “But people are doing bad.”

Just down the highway in Firebaugh, José A. Ramírez, the city manager, said a half-dozen businesses in its commercial core had closed, decimating the tax base and leaving him to “tell the Little League they’d have to paint their own lines” on the local diamond.

The situation is particularly acute in towns along the valley’s western side, where farmers learned on Friday that federal officials anticipate a “zero allocation” of water from the Central Valley Project, the huge New Deal system of canals and reservoirs that irrigates three million acres of farmland. If the estimate holds and springtime remains dry, it would be first time ever that farmers faced a season-long cutoff from federal waters.

“Farmers are very resilient, we make things happen, but we’ve never had a zero allocation,” said Stephen Patricio, president of Westside Produce, a melon handler and harvester. “And I might not be very good at math, but zero means zero.”

While California has suffered severe dry spells before, including a three-year stint ending in 1977 and a five-year drought in the late ’80s and early ’90s, the ill effects now are compounded by the recession and other factors.

Federal, state and local officials paint a grim picture of a system taxed as it has never been before by a growing population, environmental concerns and a labyrinth of water supply contracts and agreements, some dating to the early 20th century. In addition to the federal water supplies, farmers can irrigate with water provided by the state authorities, drawn from wells and bought or transferred from other farmers. Such water may not always be the best quality, said Mark Borba, a fourth-generation farmer in Huron, Calif.

“But it’s wet,” he said.

Richard Howitt, the chairman of the agricultural and resource economics department at the University of California, Davis, estimates that 60,000 to 80,000 jobs could be lost — including in ancillary businesses — and that as much as $2.2 billion in crop and other losses could be caused by restrictions on water and the drought, which he called “hydrologically as bad as 1977 and economically as bad as 1991.”

“You’re talking about field workers, processing handlers, people packing melons, trucking hay, sprayers, people selling tractors, people selling lunches to people selling tractors,” Mr. Howitt said. “And in some of these small west-side towns, it’s going to hit the people who are least able to adapt to it.”

One of the hardest hit areas is the farmland served by the Westlands Water District, which receives water exclusively from the Central Valley Project and distributes it to 600,000 acres in Fresno and Kings Counties. Sarah Woolf, a spokeswoman for the district, said that her 700 members expected to leave 300,000 to 400,000 acres fallow and that some might not come back to farm at all.

“Everyone’s trying to go down fighting,” Ms. Woolf said. “But there will be significant companies that will go out of business, as well as families that have been farming for generations, if it doesn’t get better.”

The outlook for things getting better quickly is dim, despite forecasts of rain this week. Last month, California officials estimated the snowpack in the Sierra, a primary source of water for the state when it melts in the spring, at 61 percent of normal. On Friday, the State Department of Water Resources said it would deliver just 15 percent of its promised contracts, a level it was able to maintain only because of the recent spate of rain. “It’s pathetic,” said Lester A. Snow, the department’s director.

Lynette Wirth, a spokeswoman for the United States Bureau of Reclamation, said water levels in all federally managed reservoirs in California were well below normal, with “abysmal” carryover from the previous year.

“There’s been no meaningful precipitation since last March,” Ms. Wirth said.

Farmers, of course, are also dealing with issues unrelated to rain, including tight credit from banks and recent court decisions meant to protect fish that have limited the transfer of water through the Sacramento-San Joaquin Delta, which feeds snowmelt to farmbound canals. Many farmers refer to a “man-made drought” caused by restrictions.

At the same time, environmental groups say they also fear a range of potential problems, including depletion of the valley aquifer from well pumping, possible dust-bowl conditions in areas of large patches of fallow ground and concern about salmon and other species. “It’s a tough year for the environment, and people,” said Doug Obegi, a lawyer with the Natural Resources Defense Council.

Soros on Oil and Agriculture

From Bloomberg News:

George Soros’ $21 billion fund returned 8% last year, which is incredible not only in light of the global crisis, but also given his fund’s size. As you can see, Soros is now betting big on oil and agriculture, outside of the United States.

...

Billionaire investor George Soros’s hedge-fund firm bought more shares of Petroleo Brasileiro SA and Potash Corp. of Saskatchewan Inc. in the fourth quarter, almost doubling its holdings.

Soros Fund Management LLC bought 16 million shares of the Petrobras’ U.S. traded shares, bringing its stake to 1.45 percent, according to a filing yesterday with the U.S. Securities and Exchange Commission. The New York-based firm increased its holdings in Potash by 2.6 million shares to 2 percent in the fourth quarter. Petrobras and Potash are now the firm’s two biggest reported U.S. stocks.

“As long as you see through the current crisis there are a few compelling reasons to buy,” Hernan Ladeuix, the head of oil and gas research at CLSA Ltd. in Singapore, said in an e-mail. “Oil prices should go up, probably strongly in coming years. Petrobras is the only large international company where you can have confidence that production can grow 5 percent per annum.”

The purchases made Soros the second-biggest shareholder in the U.S.-traded shares of Petrobras, Brazil’s state-controlled oil company. Petrobras preferred shares fell 5.4 percent in Sao Paulo yesterday, the most since Jan. 12, driven by a drop in oil prices to below $35 a barrel.

Potash, the biggest maker of crop nutrients, also fell by the most since Jan. 12, declining 7.4 percent yesterday. Soros Fund is the eighth-biggest holder in shares of the Saskatoon, Saskatchewan-based company.

Best Buy, Wal-Mart

Soros Fund added 9 million shares of Best Buy Co., bringing its stake to 2.3 percent of the electronics retailer. The firm also started a new position in Desarrolladora Homex SA de C.V., the Mexican homebuilder, bringing its holdings to 4.9 percent of U.S.-traded shares, according to data compiled by Bloomberg. The firm bought 5 million shares of R.R. Donnelley & Sons Co., North America’s largest printer, representing a 2.4 percent stake.

Soros’s hedge-fund firm sold 3 million shares of Wal-Mart Inc., bringing its stake in the discount retailer to 0.01 percent. The firm also sold all of its 2 million shares in Research In Motion Ltd., the maker of the Blackberry phone.

Money managers who oversee more than $100 million of equities or more must file, within 45 days of the end of each quarter, a Form 13F with the SEC that lists their U.S. exchange- traded stocks, options and convertible bonds. The filings don’t show non-U.S. securities or how much cash the firms hold.

Soros’s firm oversees $21 billion. Its Quantum Endowment Fund returned 8 percent last year. That compared with an average loss of 18 percent by hedge funds, according to data compiled by Hedge Fund Research Inc. of Chicago.

Buffett on Hyperinflation

As you can see, Warren Buffett has been loading up on bonds:

http://www.bloomberg.com/apps/news?pid=20601103&sid=ajshQre7kVYw&refer=us

"Buffett agreed to buy a combined $750 million in debt from wallboard manufacturer USG Corp., motorcycle-maker Harley- Davidson Inc. and Sealed Air Corp., the maker of Bubble Wrap shipping products, in the past three months paying between 10 and 15 percent.

"Buffett also agreed in September and October to spend $8 billion on preferred shares of General Electric Co. and Goldman Sachs Group Inc. that pay 10 percent annual interest. This month, he agreed to buy convertible notes from Swiss Reinsurance Co. worth 3 billion Swiss francs ($2.6 billion) that pay 12 percent annually."

While Buffett’s bond investments might be mandated because he is using insurance float, it stands to reason that if he was overly concerned about very high rates of inflation, he would not be doing most of these transactions.

If Buffett was concerned about high inflation or a deteriorating dollar, he would simply do what he did before: forget about yield and invest in foreign currencies. For example, he could simply buy yen forwards or yen bonds if he thought the U.S. currency faced imminent destruction.

Granted, Buffett’s recent Swiss Re position has this dollar-hedge effect. But if Buffett expected hyperinflation, he would be making very different investments. He would be investing in hard assets or securities related to them.

With high domestic inflation, anything interest-bearing or financial is rat poison – yet Buffett has been investing heavily in dollar-based, fixed-income securities. Evidently he isn’t overly concerned about high inflation.

CDO Hell

Here is a chronology of the CDO meltdown, laying bare what true junk ABS-CDOs actually were. Yet, with over 76% of these instruments that were issued at the market's peak currently in default, it stands to reason that we're pretty close to being done with this, or at least that the most intense phase of the crisis is behind us.

From the Financial Times:

Almost half of all the complex credit products ever built out of slices of other securitised bonds have now defaulted, according to analysts, and the proportion rises to more than two-thirds among deals created at the peak of the cycle.

The defaults have affected more than $300bn worth of these collateralised debt obligations, which were built from bits of other asset backed securities (ABS) such as mortgage bonds, other CDOs and structured bonds, or derivatives of any of these, according to analysts at Wachovia and Morgan Stanley.

So-called CDOs of ABS caused huge losses to banks such as Merrill Lynch, UBS and Citigroup, which held large amounts of the supposedly safest, top-rated chunks of them. They have since been damned by bodies such as the Bank for International Settlements as being too complex to risk manage effectively.

CDOs of ABS were used increasingly at the peak of the credit bubble to keep the securitisation machine moving by recycling hard to sell bits of subprime mortgage bonds and other risky tranches into new structures with top-notch credit ratings.

However, the ratings of these deals proved unsustainable, as evidenced by the fact they have accounted for 92.9 per cent of all 16,587 ratings downgrades globally from all rating agencies since the beginning of last year, according to Morgan Stanley.

The way these complex and risky transactions were exploited at the peak of the bubble can be seen in data from analysts at Wachovia, who reckon that 47.6 per cent of all CDOs of ABS by volume issued since the market substantively began in 2002 have now hit an event of default.

By their records, the first three years of the market saw less than 100 deals sold per year and less than 10 per cent of those have defaulted. The number of deals done rose to 133 in 2005, less than 20 per cent of which defaulted, and 89 in just the first half of 2006, about one-third of which have defaulted.

However, the real peak of the market saw 147 deals done in the second half of 2006 and 172 done in the first half of 2007 – of which 68 per cent and 76.2 per cent, respectively, have now defaulted.

The way these CDOs have performed has especially hurt the new wave of specialist credit hedge funds, which sprang up in recent years and became heavily dependent from creating and managing such deals. They were drawn to such business by a belief in the sustainability and predictability of the fees it would generate.

However, about one-third of the CDOs of ABS that have defaulted, or almost $105bn worth, have been or are being liquidated – often ­leading to losses for investors and putting further pressure on market prices of the bits of mortgage bonds and other CDOs they are selling.

Government-Sponsored Trainwrecks

Here are the chilling statistics on Fannie and Freddie, the housing market, and what the U.S. government is on the hook for.

From Bloomberg News:

Fannie Mae and Freddie Mac, the mortgage-finance companies seized by regulators, may need more than the $200 billion in funding pledged by the U.S. government if the housing market continues to deteriorate, Federal Housing Finance Agency Director James Lockhart said.

The companies’ needs will depend largely on the direction of home prices, Lockhart said in an interview in Las Vegas yesterday. His comments followed statements from Fannie Mae in November and Freddie Mac Chairman John Koskinen last week that the government’s funding commitment through 2009 may fall short of what the companies need to make good on their obligations.

“When we sized the amount in September, we obviously looked at stress tests and what was happening in the marketplace,” Lockhart said. “There’s been some significant events since then that weren’t in our forecast.”

The U.S. housing market lost $3.3 trillion in value last year and almost one in six owners with mortgages owed more than their homes were worth, according to a Feb. 3 report from Zillow.com. Following a record boom, home prices are down 25 percent on average since mid-2006 amid a tightening of lending standards and an economic recession, the S&P/Case-Shiller Composite 20-city price index shows.

Freddie Mac and Fannie Mae are the largest U.S. mortgage- finance companies, owning or guaranteeing $5.2 trillion of the $12 trillion home-loan market. The government seized control of Fannie Mae and Freddie Mac after their losses threatened to further disrupt the housing market, and pledged to invest as much as $100 billion into each company as needed if the value of their assets drops below the amount they owe on obligations.

A ‘Hard Look’

Fannie Mae said in a November regulatory filing that “this commitment may not be sufficient to keep us in solvent condition or from being placed into receivership.” Freddie Mac is taking a “hard look” at whether it will need more than $100 billion, Koskinen said last week.

“It’s going to be a close question,” Koskinen said in an interview on Bloomberg Television’s “Conversations with Judy Woodruff.”

McLean, Virginia-based Freddie Mac has taken $13.8 billion in federal aid and said it will need as much as $35 billion more by the end of this month. Washington-based Fannie Mae said it may tap as much as $16 billion in funding.

Lockhart, who was in Las Vegas yesterday to speak before the American Securitization Forum’s annual conference, said Fannie Mae and Freddie Mac’s most recent requests for aid, which were larger than some expected, were driven by temporary market disruptions that may not translate into permanent losses.

“There were some temporary imbalances that made their numbers pretty dramatic,” he said.

Government Demands

Federal officials are now leaning on the government- sponsored enterprises to help stabilize the housing market. House Financial Services Committee Chairman Barney Frank said last week that the companies will be used “very aggressively” to help reduce record foreclosures.

Lockhart said Fannie Mae and Freddie Mac aren’t expected to take a loss “under any program” that requires their involvement. “We would expect them to be writing business that’s profitable at this point, not a large profit,” he said yesterday. “But we would not expect them to be writing business at a loss under any program.”

The Treasury, not the companies, would bear the cost under proposals to use the companies to drive down mortgage rates to about 4.5 percent, Lockhart said. That proposal was under consideration as part of a comprehensive housing-recovery plan being developed by the Treasury.

‘A Hot Idea’

“That was a hot idea for a while: It’s cooled off,” Lockhart said. “But Fannie and Freddie wouldn’t be asked to eat the difference. If it happened, that would be the U.S. Treasury.”

Fannie Mae and Freddie Mac may also be used to provide direct financing to single-family and multifamily residential mortgage lenders, Lockhart said. Currently Fannie Mae and Freddie Mac provide financing by either buying loans from lenders or helping them package the debt as bonds for sale to investors, thus freeing up cash to make more mortgages.

The FHFA is reviewing whether the companies’ congressional charters, which generally prohibit lending directly to the public, would restrict expanding into so-called warehouse financing.

Credit Standards

Mortgage bankers and other companies that have seen their sources of credit dry up in the past year have been pushing for the change, according to Lockhart.

“The problem is that unfortunately bankers have tightened their credit standards and withdrawn from some markets,” Lockhart said. “And as interest rates fall, if we have relatively large refinancings, we’re going to need to have mortgage bankers be able to provide mortgages in the interim before they sell them to Fannie and Freddie.”

Missing the Bull's-Eye at Target

Given that I have commented on Bill Ackman and Pershing Square lately, I've included this letter to Pershing Square IV investors, who have now lost 90% of their invested capital.

As I wrote before, Pershing's TIP REIT transaction with Target was nothing more than a highly sophisticated attempt to immediately lift the stock price, and place Pershing's call options and total return swaps in the money.

But the main question that I have is, with stock prices where they are, would Bill Ackman now choose to buy Target stock, among all the other opportunities? In other words, is Target the most superior opportunity currently available?

To be clear, this is not an attack on Pershing Square or Bill Ackman, but a criticism of short-term-oriented investment strategies. With the benefit of hindsight, Ackman's leveraged Target investment appears to have been a mistake, made at the top of the market, caused by impatience.

Pershing Square IV Letter to Investors

Publish at Scribd or explore others: Finance & Investing Business & Legal target william ackman

Jim Rogers: A Retrospective

After thinking this morning about commodities and inflationary prospects, I watched a Jim Rogers interview from 1995, which I have included below. You will have to fast forward a bit, because he appears toward the end. Here are a few of his predictions from 1995:

“Next year and the year after, I don’t think we’re going to have good times in the American stock market.”

“Inflation is coming.”

“Commodity prices are going through the roof.”

Best country to invest in right now: “Iran.”

“Everything in life comes down to timing.”

Well, it looks as if Jim's timing was profoundly wrong.

In fact, much of this flies in the face of what he said in Hot Commodities, published a decade later, which was to the effect of “if you went through the 1990s and didn't touch shares in technology companies then you missed out on massive gains," essentially meaning that it was a mistake caused by not being open to new things.

But, as you can see, he was saying the exact same stuff back then as he is today. And he certainly wasn't talking about technology.

Anyone who continues saying that inflation will come or commodities will rise is bound to be proven right at some point. This not to single out Rogers as being wrong, but to emphasize my stance on how difficult it is to predict macro events – unless, that is, you only have one perennial prediction.

What history shows is that, aside from short-term macro shocks, the best asset class to own, by far, is stocks. And if you can buy those stocks at depressed prices or in periods of intense fear, then your total return can be magnified significantly.

Land, labor, capital and commodities are combined to create businesses that increase productivity. And while any one of those factors may become relatively attractive during a boom, owning excellent businesses – or fractional interests, called stocks – is the best investment over the long haul.

Keynes predicted that the great financial fortunes – paper fortunes, such as the Rothschilds in his day – would be destroyed by long-run inflation. Clearly, this has not happened.

Quite the contrary: the countries with the most developed financial systems have always been the most prosperous, whether the Medicis in Renaissance Italy, the Rothschilds in 19th-century London, or today's commanding skyscraper in Lower Manhattan that reads, simply: "85".

Thus, while the gloom and doom is persuasive nowadays, I remain highly skeptical that the world – financial or otherwise – is coming to an end. I lean more towards John Paulson's prediction that massive returns will accrue to buyers of solid, yet beaten-down financial stocks, as the smoke clears and we emerge from this crisis.

Macro Musings

Here is an interesting article on macro funds and hedge funds in general:

http://bloomberg.com/apps/news?pid=20601109&sid=ay.jqGduLoH8&refer=home

Of course, if people do “flock to global macro” as the article says, it will bankrupt the strategy.

A problem with macro over the long term is that it often comes to resemble rank gambling. Managers can make billions on each trade – or lose billions. They sell the strategy with historic bets like George Soros and sterling in 1992. But I am sure they fail to mention the innumerable historic blow-outs.

Also, the catch is that global macro is usually way more difficult than it has been lately. Over the past few years, the strategy was insanely simple: long commodities, long BRICs, short the dollar, short financials. These were one-way bets with every manager on one side of the trade.

The interesting thing is, each time this happens, everyone says that funds can’t move the market. The markets that these managers operate in are too big to be influenced – like crude oil, last summer. And then the market collapses and in hindsight we find that everyone was on one side of the trade and it created a bubble. It is important to maintain a healthy degree of skepticism with virtually everything along these lines.

A current example might be oil production and supply. I’ve heard many people make claims that production is down and supply is down, as if we’re back in 2003. So after a decade of skyrocketing prices and activity in the energy sector, production and supply are down?

This is a complete lie, no matter what the numbers say. The government or the central bank or whoever else will diligently present figures showing a certain case; but you’ll always do better using common sense. The people producing the data are backwards-looking by definition, and always way behind the curve.