Berkshire 2008 Shareholder Letter - Cliff's Notes Version

This is the thirty-second in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters from 1977-2016. For all of the prior shareholder letters, see here.

The 2008 letter weighs in at 12,760 words, a 4.8% increase from 12,170 words the prior year. Berkshire's decrease in net worth during 2008 was $11.5 billion, or 9.6% of beginning 2008 net worth.

'AMERICA'S BEST DAYS LIE AHEAD'

Reading Buffett's 2008 shareholder letter inevitably leads the reader to the conclusion that optimism is inherently stronger--not to mention financially beneficial, at least during market downturns--than pessimism. Even while the financial world appeared to be collapsing around him, Buffett had the following inspirational words to share with his readers...

Amid [today's] bad [economic] news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 211⁄2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.

Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.

With hindsight, we can see just how right Buffett was. The date the letter was released, February 27, 2009, the S&P 500 was about 10 days away from bottoming out at 666. It has since appreciated to 2,425, or a massive 464% higher than the nadir, in just over 8 years, representing a CAGR of about 16.8%.

BERKSHIRE HATHAWAY ASSURANCE COMPANY

During the financial crisis Buffett and Agit Jain used the decimation of the monoline insurers [Ambac and MBIA, principally] as an opportunity to enter the municipal bond insurance business. The entity they created was christened Berkshire Hathaway Assurance Company [or BHAC, for short] and represents an interesting case study in Buffett as entrepreneur. Buffett describes this genesis of BHAC as follows...

Early in 2008, we activated Berkshire Hathaway Assurance Company (“BHAC”) as an insurer of the tax-exempt bonds issued by states, cities and other local entities. BHAC insures these securities for issuers both at the time their bonds are sold to the public (primary transactions) and later, when the bonds are already owned by investors (secondary transactions).

By year-end 2007, the half dozen or so companies that had been the major players in this business had all fallen into big trouble. The cause of their problems was captured long ago by Mae West: “I was Snow White, but I drifted.”

The monolines (as the bond insurers are called) initially insured only tax-exempt bonds that were low-risk. But over the years competition for this business intensified, and rates fell. Faced with the prospect of stagnating or declining earnings, the monoline managers turned to ever-riskier propositions. Some of these involved the insuring of residential mortgage obligations. When housing prices plummeted, the monoline industry quickly became a basket case.

Early in the year, Berkshire offered to assume all of the insurance issued on tax-exempts that was on the books of the three largest monolines. These companies were all in life-threatening trouble (though they said otherwise.) We would have charged a 11⁄2% rate to take over the guarantees on about $822 billion of bonds. If our offer had been accepted, we would have been required to pay any losses suffered by investors who owned these bonds – a guarantee stretching for 40 years in some cases. Ours was not a frivolous proposal: For reasons we will come to later, it involved substantial risk for Berkshire.

The monolines summarily rejected our offer, in some cases appending an insult or two. In the end, though, the turndowns proved to be very good news for us, because it became apparent that I had severely underpriced our offer.

Thereafter, we wrote about $15.6 billion of insurance in the secondary market. And here’s the punch line: About 77% of this business was on bonds that were already insured, largely by the three aforementioned monolines. In these agreements, we have to pay for defaults only if the original insurer is financially unable to do so.

We wrote this “second-to-pay” insurance for rates averaging 3.3%. That’s right; we have been paid far more for becoming the second to pay than the 1.5% we would have earlier charged to be the first to pay. In one extreme case, we actually agreed to be fourth to pay, nonetheless receiving about three times the 1% premium charged by the monoline that remains first to pay. In other words, three other monolines have to first go broke before we need to write a check.

Two of the three monolines to which we made our initial bulk offer later raised substantial capital. This, of course, directly helps us, since it makes it less likely that we will have to pay, at least in the near term, any claims on our second-to-pay insurance because these two monolines fail. In addition to our book of secondary business, we have also written $3.7 billion of primary business for a premium of $96 million. In primary business, of course, we are first to pay if the issuer gets in trouble.

We have a great many more multiples of capital behind the insurance we write than does any other monoline. Consequently, our guarantee is far more valuable than theirs. This explains why many sophisticated investors have bought second-to-pay insurance from us even though they were already insured by another monoline. BHAC has become not only the insurer of preference, but in many cases the sole insurer acceptable to bondholders.

Nevertheless, we remain very cautious about the business we write and regard it as far from a sure thing that this insurance will ultimately be profitable for us. The reason is simple, though I have never seen even a passing reference to it by any financial analyst, rating agency or moonlike CEO. The rationale behind very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely reflects the experience of entities that issued uninsured bonds. Insurance of tax-exempt bonds didn’t exist before 1971, and even after that most bonds remained uninsured.

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belt-tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Local governments are going to face far tougher fiscal problems in the future than they have to date. The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at yearend 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering.

When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?

Insuring tax-exempts, therefore, has the look today of a dangerous business – one with similarities, in fact, to the insuring of natural catastrophes. In both cases, a string of loss-free years can be followed by a devastating experience that more than wipes out all earlier profits. We will try, therefore, to proceed carefully in this business, eschewing many classes of bonds that other monolines regularly embrace..

Fast forward to last year and we find from Berkshire subsidiary National Indemnity's website [link here] that BHAC had total assets of $2.22 billion and Total Policyholders' Surplus of Total Policyholders' Surplus of $1.50 billion, each as of September 30, 2016, and maintained a Standard & Poor's Rating of AA+. BHAC was not important enough to merit a mention in the 2016 annual report, however.

MISTAKES OF COMMISSION - IRISH BANKS EDITION

Buffett in the 2008 letter describes a few investing mistakes of commission [as opposed to mistakes of omission] he had recently made. One that merits inclusion in this discussion was that '[d]uring 2008, [Buffett] spent $244 million for shares of two Irish banks that appeared cheap to [him]. At year-end [2008] [Berkshire] wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call [Buffett's] mistakes “unforced errors.”' From the vantage point of 2017, we can look back at these banks - likely he was referring to Allied Irish Banks [AIB] and the Bank of Ireland [BOI], both of which were listed on U.S. exchanges in 2008 - and see how they have fared since Buffett wrote the investments down 89% at the end of 2008. AIB now trades at just 1.6% the level it traded in January 2009 [source here], in effect being a total wipeout, whereas BOI trades today at just 55% of the level of January 2009 [source here], not quite a complete wipeout but still pretty atrocious. Sometimes a company that 'looks cheap', even to Warren Buffett, can prove to be disastrously expensive in retrospect, demonstrating how difficult the investing game can really be [not everybody goes all in on Google or Amazon upon their IPO and just holds forever].

GREATEST INVESTMENTS USUALLY GREETED WITH 'YAWNS'

An aside from the 2008 letter is worth including here - namely, that often the best investing ideas go unacclaimed at inception. This is logical, as the best investments are normally those others cannot recognize in real time, which is precisely why they are available [if people recognized them, obviously good opportunities would quickly be snapped up]. Buffett explains...

The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns.

CONCLUSION

For the record, in 2008 Berkshire's stock declined 32%, beating the S&P 500 by 5% [hey, a win's a win, folks], the Phillies topped the Rays 4-1 in the World Series and the Steelers beat the Cardinals in a thrilling finish 27-23 in Super Bowl XLIII. Next up, 2009, the year of 'green shoots' and the beginning of the Obama presidency.