2005: How can investors comfortably invest financial services when many triple-A rated companies have false and misleading financials?

AUDIENCE MEMBER: Thank you. Bill Ackman from New York, New York.

Four of the handful of triple-A rated companies — AIG, Fannie Mae, Freddie Mac and MBIA — are under formal investigation for accounting shenanigans and are in the process of restating their financials.

Like Charlie said before, I think of a triple-A rated company as an exemplar, a company that should behave with the highest accounting and ethical standards.

My questions this leads me to are, how can investors comfortably invest in any financial service company when even — when a decent percentage of the triple-A rated companies have false and misleading financials?

And I guess the follow-up question is, why don’t the rating agencies do some independent due diligence from an accounting standpoint so that they can help serve as a watch on this issue?

WARREN BUFFETT: Well, financial companies are more difficult to analyze than many companies.

I mean, the — it is more — if you take the insurance business, you know, the biggest single element that is very difficult to evaluate, even if you own the company, is the loss and loss adjustment expense reserve.

And that has a huge impact on reported earnings of any given period. And the shorter the period, the more the impact can be from just small changes in assumptions.

You know, we carry, we’ll say 45 billion of loss reserves. But, you know, if I had to bet my life on whether 45 billion turned out to be a little over or a little under, I mean, it’d be a — I’d think a long time.

And you could just as easily have a figure of 45 1/2 billion or 44 1/2 billion. And if you were concerned about reporting given earnings in a given period, that would be an easy game to play.

In a bank, you know, it basically is whether the loans are any good. And I’ve been on the boards of banks. And that’s — you know, I’ve gotten surprises. It’s tough to tell.

It’s — financial companies — if you’re analyzing something like WD-40, you know, or See’s Candy, or our brick business, or whatever, you know, they may have good or bad prospects but you’re not likely to be fooling yourself much about what’s going on currently. But with financial institutions, it’s much tougher.

Then you add — throw in derivatives on top of it, and, you know, it’s — no one probably knows, you know, perfectly, what some of the — or even within a reasonable range — the exact condition of some of the biggest, you know, banks in the world.

And — but that brings you back to the due diligence question of the agencies. You had very high-grade, very smart — financially smart — people on the boards of both Freddie and Fannie. And yet, you know, one was five billion and one was apparently nine billion.

Those are big numbers. And I don’t think those people were negligent. And it’s just, it’s very, very tough to know precisely what’s going on in a financial institution.

Charlie and I were directors of Salomon [Brothers]. And Charlie was on the audit committee. And I forget the size of a few of those things that you found. But, you know, what wasn’t found — and that doesn’t mean that people below are crooks or anything like that.

It just means that it’s very tough with thousands and thousands and thousands of complicated transactions, sometimes involving — the computations involving — multiple variables, it can be very hard to figure out where things stand at any given moment.

And, of course, when the numbers get huge on both sides, and you get small changes in these huge numbers, they have this incredible effect on quarterly or yearly figures because it all comes lumped in — those adjustments — come lumped in a short period of time.

So I just think you have to accept the fact that insurance, banking, finance companies — we’ve seen all kinds of finance company — both frauds and just big mistakes over time — of just one after another over the years.

And the — it’s just a more dangerous field to analyze. It doesn’t mean you can’t make money in it. We’ve made a lot of money on it. But it’s difficult.

Now, obviously a GEICO, where you’re insuring pretty much the same thing — auto drivers — and you get — your statistics are much more valid in something like that than they will be if you’re taking something that — like asbestos liability — you’re subject to far greater errors in estimation.

Doesn’t mean that people aren’t operating in good faith. But, you know, I would take — just take the asbestos estimates of the 20 largest insurance companies. I will bet you they’re way off, but I don’t know in which direction. And that’s sort of the nature of financial companies.

I wouldn’t fault the rating agencies in terms of not being able to dig into the financials and find things that —

You know, all of the companies that you’ve talked about have had big name auditors. And our auditors at Berkshire, how many hours did they spend last year?

You know, I don’t know whether — what it would be, probably 60, 70,000 hours. And I’m sure at other — you know, if you take major banks, they’re spending more than that. But, you know, can they be certain of the numbers? I doubt it.

Charlie?

CHARLIE MUNGER: Yeah. Warren is obviously correct that where you’ve got complexity, which by its very nature provides better opportunities to be mistaken and not have it come to notice, or to be fraudulent and have it not be found out, you’re going to get more fraud and mistakes than you are if you’re selling a business where you shovel sand out of the river and sell it by the truckload.

And just as a business that sells natural gas is going to have more explosions than a business that sells sand, a business like these major financial institutions, by its nature, is going to have way more problems.

And that will always be true. And it’s true when the financial institutions are owned by governments.

In fact, some of the worst financial reporting in the world is done by governments and governments — institutions like government banks in China, et cetera.

So, if you don’t like the lack of perfect accounting in financial institutions, you’re in the wrong world.