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Why Warren Buffet Has Never Been More Wrong

May 5, 2008

Just a couple of days ago, the financial media rejoiced over a prediction made by the Omaha oracle, Warren Buffet that “The worst of the crisis in Wall Street is over,” disseminating this declaration across the world in the hopes that it could continue to fuel what will go down as one of the most foolish stock market rallies in history. However, in all the articles I read that covered his declaration (and there were many), I couldn’t find one that actually discussed in detail any of the reasons why Mr. Buffet believes that recent actions taken by the U.S. Federal Reserve are sustainable. It seemed that most journalists were quite content with applying the logic of “if Mr. Buffet said it, it must be true.”

Those of you that are maalamalama Platinum Members know that Mr. Buffet’s declarations of the fallout that likely would have ensued had the U.S. Federal Reserve not bailed out Bear Stearns could have been lifted almost verbatim from my bulletin I had sent to you over a month ago. Recently, Mr. Buffet reiterated exactly what I had told all of my Platinum Members in that month-old bulletin, that if Bear Stearns had gone bankrupt, other Wall Street firms and banks would have failed within a matter of days and the Dow would easily have shed another 1,000 points also in a matter of days. But here’s where I believe Mr. Buffet is wrong. At his annual meeting of his Berkshire Hathaway company, he stated, “ I think the Fed did the right thing in stepping in on Bear Stearns.” So why do I think he’s wrong if I think Bear’s collapse would have created much sharper pain in the U.S. stock markets and the collapse of other financial institutions?

To begin, The U.S. Federal Reserve’s complicity in dismantling the Glass Steagall Act, their refusal to encourage Congress to regulate derivative markets, and their debasement of the dollar all have directly contributed to the debacle that created Bear Stearns’s collapse (I know that is a very simple argument, but it would literally take me 100 pages to explain all the intricacies of how the Federal Reserve very cleverly creates the problems that affect the financial world while claiming ignorance of their hand being firmly in the worldwide financial pot). In essence for Mr. Buffet to declare that the Fed “did the right thing” would be analogous to me praising a country for sending minesweepers into a local village to clear 300,000 landmines that they had planted in their fields. But this is where the analogy ends.

Clearing the 300,000 landmines is a positive act that will vastly improve the health of the local village and no doubt prevent many future deaths. The Fed’s action to bailout Bear Stearns is analogous to planting armed soldiers at the perimeter of the fields and not allowing anyone to enter instead of clearing the fields of the mines. On the surface, everything appears fine because there will be no further deaths even though the problem has not been solved. Eventually, when the soldiers leave and the villagers necessarily re-enter the fields to reach the local markets to buy water and food, villagers will re-discover that the problems never went away and villagers will die. Eventually, time will prove the end result of the Federal Reserve’s actions to bailout Bear Stearns to be much more similar to this scenario. The Fed’s actions have produced the appearances that everything is okay without doing anything to solve the problems.

So let’s explore if there is any justification to Mr. Buffet’s statement that the “Feds did the right thing” and that “the worst of the crisis in Wall Street is over.” In essence, JP Morgan threw a lifeline to Bear Stearns that would not have happened without the blessings of the U.S. Federal Reserve as JP Morgan was ready to walk away from the deal and Bear Stearns was set to collapse the following Monday. Enter the U.S. Federal Reserve with a $29 billion promise to JP Morgan that guaranteed JP Morgan’s buy out of Bear Stearns, with most of the Reserve’s $29 billion collateralized solely by mortgage-backed securities on Bear Stearns’s books. Reserve Chairman Ben Bernanke said that their $29 billion guarantee is not in danger of being called by JP Morgan because the mortgage-backed securities are of “high credit ratings”. Thus, Bernanke concluded that everyone who called the $29 billion offered by the Reserve to make the deal work is patently wrong. Ummmm, if the $29 billion guarantee is not in any danger of ever being called, then why was it 100% necessary to convince JP Morgan to agree to move forward with the deal?

If Ben Bernanke doesn’t understand by now that credit ratings on mortgage backed securities are virtually meaningless, then he should resign tomorrow. I say that sarcastically as I know that Mr. Bernanke fully understands how meaningless the U.S. credit rating system is today. He obviously makes such comments to fool the sheep herd that subscribe to the mantra of ignorance is bliss. Ultimately, JP Morgan is much more likely to call on a large portion of the Federal Reserve’s $29 billion guarantee than not, which means the Reserve will then have to print more monopoly money and push an untenable situation that presently teeters on a cliff into an even more untenable situation. Ultimately this is why the Federal Reserve and Warren Buffet are both wrong.

Furthermore, it’s not like banks have never failed before. People seem to think that bailouts are the only solution and that Armageddon will arrive if we don’t bail out these banks. The reality is that the actions undertaken by the U.S. Federal Reserve are exacerbating the problems, not making them better. Economies across the world have experienced multiple bank failures before only to emerge much stronger in future years. The U.S., is unwilling to endure such maneuvers that would be tantamount to political suicide during an election year. Normally in an election year, the incumbent government will do everything in their power to artificially manufacture a strong economy and stock market as a strong economy has the greatest singular correlation to winning an election. Today, the government with the help of the U.S. Federal Reserve, has a much different agenda – do everything in their power just to keep things from falling apart until after the election in November. Banks that engage in zero risk management and put bottom line profit and greed on the top of their mantle and thus fail deserve to fail, as their failures are a natural progression of a free market. The only part of this equation that does not deserve the fallout are naïve stockholders, but stockholders inevitably only get hurt during these bank failures due to the outright immoral behavior and bold faced lies of the executives managing these institutions.

If the executives didn’t outright lie month after month after month to their shareholders about the true state of affairs at their institutions, there would be an orderly exit from their shares, the shares would decline month after month, but shareholders would have a chance to exit with minimal losses instead of having to offload shares in a panicked stampede that results when management perpetually suppresses the truth until the truth can no longer be hidden from the public. In any event, even bank failures cause short-term pain in the economy to be amplified, such a weeding out process is 100% necessary to the recovery of an economy as the economy’s financial industry will be much strengthened by the weeding out of charlatans and the elimination of those companies most guilty of employing little or no risk management in the pursuit of profits. The strong recovery of the Asian tigers after the 1997Asian financial crisis bears out this point. I would argue that bailouts are then anti-free market and anti-constructive when trying to turn an economy around with solutions sustainable longer than several weeks or several months.

Instead of extolling the virtues of free-market intervention to reward outright deception and greed that will most likely end up poorly for the common American taxpayer as such actions will almost certainly cause the dollar to lose future purchasing power, we should be taking a closer and much more critical view. It’s not just this one act per se, because $29 billion is not a large sum compared to the $17 trillion or greater supply of dollars tumbling around the system worldwide. But that’s just my point. The numerous, intervening inflationary actions undertaken by the U.S. Federal Reserve over the past few months similar in nature to their bailout of Bear Stearns have had the aggregate effect of trivializing a $29 billion cash infusion as “nominal” because in comparison to the hundreds of billions of dollars being made available through unprecedented Term Auction Facilities, it is a small amount. And when $29 billion becomes a trivial figure due to debased currencies in highly inflationary environments, that’s dangerous. While these collective actions can serve to maintain the illusions of hope, they certainly have not contributed any meaningful discourse towards a path of sustainable economic recovery. And for this reason, Warren Buffet is wrong. The Peak Investment Crisis is still very much alive and it’s time to brace yourself for the worst, unless of course, you actually enjoyed the interest rate environment of the Paul Volcker/ Jimmy Carter years. To learn how to prosper from the coming crisis, visit us at maalamalama.

[tags]global recession, economic crisis, Warren Buffet, hyperinflation[/tags]

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