Investment Wisdom

86. Wesco 2007: Let’s Learn Some More- Part 4 – Points 19-24

Lesson 19. Subprime Crisis – Some originators belong to lowest circle of hell

Subprime and the rating agencies

The rating agencies have prospered mightily, and their most likely source of embarrassment is subprime paper. Overall, they do a good job, and you always miss things with the benefit of hindsight. I would not predict they encounter great distress. If you want to pick things to disapprove of, the rating agencies would be far down on the list.

You might pick many originators of the subprime mortgages. They are some of the most disgusting people we’ve been able to produce, and many of them belong in the lowest circle of hell. There will always be such people, making money by misleading people. You’ll always get people like the worst commissioned salespeople in the mortgage brokerage business. This isn’t the real tragedy.

The real tragedy is the people higher up at the Wall Street banks who only asked if they could sell it, not if they should do it. They violated engineering principles and ethical principles. There’s nothing wrong with giving a mortgage to the deserving poor. Here’s a guy who’s working hard, etc., and even if you give him a 90% or 100% mortgage, he’ll pay it. Making such loans worked and was good for us and the nation.

But if you look for the undeserving, dishonorable, addicted people with silly views on their own entitlement – if you start giving them phony mortgages so they can drink more, gamble more – it’s like pouring gasoline on the floor and throwing a match. I would argue that in very high places in America, it’s not enough to call it folly. It’s sin-folly.

It’s sad that that much terrible behavior came in, due to the self-serving bias. Because they made easy money doing it, they rationalized it.

Dean Kendall of the University of Michigan music school once told a story: “When I was a little boy, I was put in charge of a little retail operation that included candy. My father saw me take a piece of candy and eat it. I said, “Don’t worry. I intend to replace it.” My father said, “That sort of thinking will ruin your mind. It will be much better for you if you take all you want and call yourself a thief every time you do it.”

It’s a good story and we need more Dean Kendalls in the high reaches of American business. This and envy cause so much trouble. They account for so much of what you see in the abuses of the subprime field.

We knew how to do it once. The subprime for the deserving poor worked, but egalitarianism and biases led to a big mess.

Lesson 20. Declining dollar did not necessarily lead to inflation

Why hasn’t the declining dollar led to increased inflation?

The dollar’s been going down like crazy, but the prices at Costco [Munger’s on the board] have shown no inflation for many, many, many years. It’s a good question. A lot of economics professors would say it couldn’t happen, but it did. It’s very important.

There’s been an unusual set of circumstances. It’s easy for me to tell you it matters. But how it matters – if I were able to do that, I wouldn’t be qualified to sit here. The answer is, I don’t know.

Lesson 21. Envy is a huge motivator, though it’s seldom admitted. In my whole life, I’ve never had someone say, “Charlie, I’m doing this out of envy.”

Is there a trend in the private equity business?

Of course there’s a trend. The LBO funds get larger and larger and buy larger and larger businesses, so it’s a huge trend.

It’s a different lifestyle than Berkshire’s. We almost never sell – we don’t want to do that. We don’t want to play gin rummy with our friends, dumping five businesses and getting five new ones. We aren’t buying to resell.

The leveraged equity crowd is getting bigger and bigger and bigger. What’s happened is endowments and pension plans are believing in the tooth fairy. With assets being bid up, they’re not getting enough return from ordinary investments from stocks and bonds.

Then silver-tongued people came along and said you don’t have to suffer low returns. Give us the money, we’ll lever up, pay us a lot of compensation and we will give you 15% not 5%. It’s worked – not as well as claimed; there’s dubious use of statistics – but for good shops, it works.

Then, a lot of envy sweeps the field. Yale can’t stand Harvard making more. Envy is a huge motivator, though it’s seldom admitted. In my whole life, I’ve never had someone say, “Charlie, I’m doing this out of envy.”

In venture capital, except for a handful of firms at the top, the returns are lousy. This will eventually happen to the LBO firms as well. God has not decided that anyone who wants 15% can get it.

Lesson 22. A nonprofit can be true to its word.

How do you invest the funds of the hospital you’re chairman of?

The nonprofit hospital of which I am the chair is really nonprofit. It loses so much money in a good year it’s awkward and a bad year is something awful. Given the conditions under which we labor, we leave all money in short-term instruments. We need all our assets in a liquid reserve.

I’d like to have a hospital where my biggest problem is what to do with the surplus, but that has not been my lot in life.

I don’t think hospitals have different investment needs than other places. I don’t think the investment process would be any different.

Lesson 23. Investment bankers were better when I was young. They used to care about the quality of deals – they cared a lot.

Comment on UnitedHealth, its CEO and the options backdating scandal there

It’s hard to say anything but that that was very regrettable behavior. The man lost his job and he deserved to.

View of lawyers

The standard way lawyers think is to weigh both sides. There’s forced objectivity and a procedural system. That’s a huge plus. So if that’s what you’re talking about regarding law practice, that’s good, but there’s a lot that’s not good, a lot that’s drifted away. It’s not at all uncommon that billing rates will exhaust the amount in dispute before you get to trial. If you’re doing this as a lawyer, that’s a moral minefield.

The legal profession attracts a lot of smart people who can express themselves well in words and numbers. There are many good people coming out because many good people are going in. Yet much of what law schools do is a joke.

View of investment bankers

At Salomon we asked, “Where is the list of things you won’t do because they’re beneath you?” We never saw it. Envy and greed lead people to doing almost anything that looks profitable and does not require use of a machine gun. Investment bankers were better when I was young. They used to care about the quality of deals – they cared a lot.

Ethics attenuated a lot. This was not good. The deterioration would be an interesting subject for social science. You’d have to understand psychology – it would be very difficult for somebody to do it.

Why is the high road the best way in investment banking? It’s not very crowded.

[Laughter]

Lesson 24. Mental checklist. I’m a great believer in solving hard problems by using a checklist. You need to get all the likely and unlikely answers before you; otherwise it’s easy to miss something important.

The possible rise of protectionism

It’s hard to predict if there will be a lot of protectionism. At the current time, a flood of imports is changing the world. Some ordinary guys are having a tougher time and feel that China is oppressing them.

MENTAL MODELS

Using mental checklists

I’m a great believer in solving hard problems by using a checklist. You need to get all the likely and unlikely answers before you; otherwise it’s easy to miss something important.

http://www.valuewalk.com/wp-content/uploads/2014/05/Charlie-Munger-2005-2013-minus-Harvard-Westlake.pdf

Notes from 2007 Wesco Financial Annual Meeting – By Whitney Tilson