"Un-Buffett Like Comments by Warren Buffett"

Sydney M. Williams

Thought of the Day

“Un-Buffett like Comments by Warren Buffett”

June 7, 2010

Warren Buffett is, deservedly, the paragon of global investors, which is why his testimony before the Financial Crisis Inquiry Commission in New York last Wednesday was so disappointing.

Mr. Buffett was subpoenaed to testify, having declined an invitation, as the largest shareholder of Moody’s – whose business model he has described as “bullet proof” and “extraordinary.” The description is apt, as the business is an oligopoly, of which three companies, Moody’s, Standard & Poor’s and Fitch have the majority share. The SEC permits investment banks and broker dealers to use credit ratings from “Nationally Recognized Statistical Rating Organizations” NRSROs, of which, as of 2008, there were ten, five in the U.S. Besides the three listed above, the other two American companies are A. M. Best and Egan-Jones Rating Company. A. M. Best works principally with insurance companies. Egan-Jones is paid by investors, not issuers.

While the business of Moody’s was “bullet proof”, according to Mr. Buffet, and that was the principal reason for his investment, he claimed that he personally does not rely on credit ratings when making investment decisions. He makes his own judgment. “What we hope for,” Mr. Buffett said, “is misrated securities because that would give us a chance to make a profit if we disagree with the rating agencies.” That makes good investment sense, but does not seem like a good reason to excuse the rating agencies for having misled other investors. His defense of Moody’s and Moody’s CEO, Raymond McDaniel that they were “among many who missed warning signs of the crisis” just doesn’t hold up. Investors rely on the rating agencies because of their supposed diligence and insight, and their quasi-government affiliation. Nevertheless, Mr. Buffett added, “In this particular case, I think they made a mistake that virtually everybody in the country made,” so removing Mr. Daniels is “not necessary.” Arguing that agencies were among the many who missed warning signs of the crisis may be a true statement, but placing “virtually everybody in the country”, on an equal setting, with the supposed gate-keeping experts, which are the rating agencies, is a flimsy defense.

Mr. Buffett went on to say, “I’m not arguing that this is a perfect model [the rating agency model, paid for by the issuers]. It’s very difficult to think of an alternative where the user pays. I’m not going to pay.” That statement is contradicted by his statement that he does not rely on the rating agencies. He does his own work, which means he is paying, either his staff or outside analysts; so he is using an alternative.

In speaking of the housing bubble, Mr. Buffett said, “Rising prices are a narcotic that affects the reasoning power, up and down the line.” Again, a true statement, but over the years Mr. Buffett has made great use of “Mr. Market” who takes advantage of emotional swings in markets; so one would think he must have seen Moody’s falling victim to just that emotion – that their persisting with AAA ratings for securities that were becoming increasingly irrational – would have caused him to question their judgment? But perhaps, since he personally ignored their credit ratings he was fine, as long as most investors continued to use them?

It seems to me that Mr. Buffett, who is as wise and plain spoken as any investor of the last half century, could have used the forum to argue that a basic problem with the system is that rating agencies are paid by the issuers, thereby establishing an inherent conflict of interest. While he claims he cannot see an alternative, he uses one himself – conducting his own independent research.

Larry Harris, in Friday’s Financial Times, suggests a contingent compensation system, whereby some percent of the fees paid to the Credit Rating Agencies (CRAs) be placed in escrow and released over time based upon the performance of the bonds. Cash flow needs of the CRAs could be had by borrowing against the escrowed funds. The lenders would, effectively, rate the raters instead of the government. It drastically would change the business model, but we know the current one does not work.

Representative Barney Frank would force credit raters to register with the SEC and allow investors to sue them for assigning recklessly high ratings. Senator Al Franken wants a new regulatory board to choose the rating agencies that analyze each bank deal. Both proposals would add to an already bloated government and would serve to give a more entrenched “government approval” to ratings – permitting, perhaps, less independent analysis and more reckless behavior than we now have. Besides which any new government agency is grist for lobbyists. The ability to sue, despite appealing to trial lawyers, should always be an option.

It makes more sense, in my opinion, to adapt what Mr. Buffett does already. Investors should be responsible for doing their own due diligence. Whatever information CRAs now receive from the businesses, agencies and governments whose bonds they rate should be available to all parties. It should be a level playing field. Investment banks should be disallowed from providing research on their own debt – on mortgages they create, or on all other products they create or issues they underwrite. Individual investors would rely on research from those that sell it, just as they do today for equity investments. On May 3rd I wrote a “Thought of the Day” entitled “Rating Agencies – Do We Need Them”. My answer then and still is “no”. Whatever void would be created by their absence would be filled by new and old firms clamoring to get into the credit research business. The new firms would represent investors, not issuers. Those that do well will thrive. Those that do not will fail.

But Mr. Buffett whom we all admire as the world’s foremost investor did not take advantage of the opportunity he had to suggest a better way. He came across as a defender of a firm, which saw 90% of its investment-grade ratings in 2007 become relegated to junk. It makes no difference that “they made the same mistake virtually everybody in the country made.” They were supposedly the experts; the ones who had done their due diligence upon which most investors depend. It seems obvious, despite protestations to the contrary, that Mr. Daniels was more interested in market share than in accuracy. In this instance, “Mr. Market” missed his opportunity. I expected more from Mr. Buffett.

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Tomorrow I will be in Massachusetts for the Big Brothers Golf Outing – a worthy cause, but a sport at which I am abysmal. If victory were based on the most swings taken, I would be lauded and covered in roses; alas, that is not the way in which golfers are judged.