Buffett's Dictum
By Adrian Ash
September 27, 2007
Risk has been abolished –
and even the TV news anchors can grasp that idea...
"IF YOU UNDERSTOOD a business perfectly
and the future of the business, you would need very little in
the way of a margin of safety," said Warren Buffett at
Berkshire Hathaway's annual meeting in 1997.
He had first issued his famous dictum twenty years
earlier. Buffett referred to it again in 2005.
"We [only] borrow money against portfolios of
interest-bearing receivables whose risk characteristics we
understand," he told his shareholders...and the BRK
faithful just loved it.
Understanding where you're putting your money –
knowing how it will be used, and knowing the likelihood of
getting it back – reduces your risk, in short. If you don't
understand an investment, then the "unknown unknowns"
threaten to eat you alive.
Appears sound in theory, right? But does anyone
outside of Gorat's steakhouse in Omaha today – Buffett's
favorite diner according to BRK mythology – even begin to care
if it's true?
"Although the dislocations, especially to
short-term funding markets, have been large and in some cases
unexpected," the International Monetary Fund just reported,
"the event [of the world credit crunch] hit during a period
of above-average global growth."
Moreover, added Rodrigo Rato, the IMF's managing
director, in a Moscow press conference Tuesday, "the
evolution of recent days is moving towards normalization."
"The most important financial institutions
have enough capital to withstand the shock," Rato
explained. And amid the crisis in confidence and "state of
turbulence" hitting the financial sector, "we welcome
the actions of central banks to maximize liquidity," he
announced.
Trouble is, maximizing liquidity – the
availability of money – is what created this mess in the first
place. Failing to understand this plain fact is what led the
United Kingdom, the world's fourth largest economy, to suffer
its first genuine banking run in more than a century. Here in
London, all progress in finance since 1878 just got wiped out.
Yes, the City and its regulators have swapped
whiskery chops and black stove-pipe hats for ShockWave hair gel
and pink gingham shirts. But they're no more
"sophisticated" than were their Victorian forebears.
And as the IMF report proves, it's not only London that's failed
to grasp the risks facing global finance today.
The run on Northern Rock (NRK) came thanks to the
very "liquidity" that Rodrigo Rato of the IMF says
he's glad to see pouring out of central banks once again. NRK
was a top-five mortgage lender that gathered £24 billion in
saving deposits but lent out £113 billion. It raised the
difference by borrowing short-term funds in the money markets.
Did anyone inside Northern Rock understand the
risks inherent in "maximizing liquidity" so
aggressively? Didn't the Bank of England or Financial Services
Authority grasp the dangers this high-profile bank was storing
up on its balancesheet? Evidently not – and why would they?
By the end of June, NRK's total exposure to
subprime US home-loans represented only 0.24% of its total
assets. Hot on the heels of the Bear Stearns' hedge-fund
collapse at the start of the summer, this meant NRK was deemed
safe from the chaos of failing mortgage-backed bonds relying on
low-income US home-buyers for repayment.
Not that London's financial leaders were alone in
their error. The mass of British investors also mistook NRK's
tiny subprime exposure for evidence that it was safe. NRK was
one of the five most popular shares bought by private UK
investors in the last week of August. Since then, however, NRK's
stock has sunk by 75%.
Pictures of anxious savers queuing outside NRK's
branches on the High Street also destroyed confidence in the
Bank of England and Financial Services Authority – the
government-mandated watchdogs supposed to understand, monitor
and cap its risky behavior. The media's panic, shocked at the
very idea that a financial firm might ever go under, then forced
London's government of amateur financial idiots to guarantee all
savings for all savers wherever they bank.
Risk has been abolished, in short – a concept
even the TV news anchors can grasp. So who cares that it's not
true?
"Whatever system is put in place to safeguard
[UK bank] deposits following the run on Northern Rock,"
says a letter to the Financial Times, "it is
important that it is understandable to savers. I wonder how many
savers understood the workings of the Financial Services
Compensation Scheme before its recent coverage in the
press?"
The British equivalent of the FDIC, this
Compensation Scheme – it was revealed Tuesday – now holds
funds of just £4.4 million. Total UK bank deposits, on the
other hand, total some £1.6 trillion. It doesn't matter that,
in the wholly unlikely event of a total collapse in British
banking, the fund could offer only 0.00002% in compensation.
Forget the fact, too, that the US insurance scheme by comparison
holds 5,000 times as much cash for a population only five times
the size.
The point is that the FSCS in London was allowed to
promise insurance worth £31,700 to each of Britain's cash
savers (just less than $64,000) – and to continue making this
promise – without anyone bothering to even imagine that the
policy might ever needed.
The United Kingdom also has the Banking Code,
a 36-page document setting out standards of behavior agreed by
the vast majority of retail banks and building societies. But
the state-owned monopoly Post Office has yet to sign up to the Code.
And the Code itself does not mention the word
"risk" once. Nor does it talk about
"safety". The sole preoccupation, as with today's
bubble-friendly banking regulations everywhere, is with honesty
in marketing.
Honesty about the raw fact of banking deposits –
that your money is at risk the moment you let someone else lend
it out for a profit – just doesn't figure.
In the United States too, the very concept of
"risk" has been long forgotten as a warning. Indeed,
for Bank of America's current marketeers, it's now just a
tool...a branding technique to prop up tired advertising exec's
when they're all out of ideas.
The biggest bank in the US currently offers what it
calls the "Risk Free CD". Never paying less than 4.75%
during its 11-month term, the Risk Free cash deposit actually
comes with no more, or less, risk than any other US savings
account. It's only claim to safety is that you can "count
on the security of FDIC insurance up to $100,000 on your
accounts," says the marketing blurb.
Yes, that's what makes the "Risk Free CD"
so free of risk...the same FDIC promise as every other bank
account in the United States. The risks to your money are no
different to the risks incurred by holding your cash anywhere
else. And thus the "risk free" sticker on BoA's
"Risk Free CD" is simply there to make 4.75% interest
sound unique, intriguing, perhaps even attractive.
Who outside Wall Street, the City, Frankfurt's
glass towers or Tokyo's Kabutocho district can understand that?
Who on the inside even cares?