2007: What's going on in the sub-prime market?

AUDIENCE MEMBER: What’s your opinion regarding the subprime market relative to the foreign national market? Sorry. My name is Calvin Chong (PH). I’m from New York.

WARREN BUFFETT: Well, the subprime market, encouraged by both lenders, intermediaries, and borrowers themselves, resulted in a lot of people buying a lot of houses that they really didn’t want to own or that they can’t make payments on for once the normal payments were required.

And the people, the institutions, in some cases the intermediaries, are going to suffer in various degrees.

Now, the question is whether it spills over and starts affecting the general economy to a big degree, and I would — my guess would be — it’s quite severe some places.

But my guess would be that if unemployment doesn’t rise significantly, and interest rates don’t move up dramatically, that it will be a — it will be a very big problem for those involved, and some people are very involved. Some institutions are very involved.

But I don’t see it — I think it’s unlikely that that factor alone triggers anything of a massive nature in the general economy.

I think it — you know, I’ve looked at several financial institutions. I’ve looked at their 10-Qs and 10-Ks, and I’ve seen that a very high percentage of the loans they made in the last few years allowed people to make very tiny payments on the mortgages, but, of course, those subnormal payments increased principal so that they had to make above average payments later on at some point.

And I think that’s dumb lending, and I think it’s dumb borrowing, because somebody that can only make 20 or 30 percent of their normal mortgage payments the first year is very unlikely to be able to make 110 percent of their normal mortgage payments a few years later.

Those people and those institutions were largely betting on the fact that house prices would just keep going up, and it really didn’t make any difference whether they could make the payments.

And that worked for a while until it didn’t work. And when it doesn’t work, you have an abnormal supply of housing coming on the market, similar to what happened in manufactured housing, the business we’re in, six or seven years ago, and that changes the whole equation.

From people on the demand side, you no longer have people thinking they’re buying something that’s bound to go up, and then you have the supply coming on from the people who were anticipating that before and really don’t want to hold the asset unless it’s going to go up.

So you’ll see plenty of misery in that field. You’ve already seen some. And I don’t think — I don’t think it’s going to be any huge anchor to the economy.

Charlie?

CHARLIE MUNGER: Yeah. A lot of what went on was a combination of sin and folly, and a lot of it happened because the accountants allowed the lending institutions to show profits on loans where nobody in his right mind would have showed any profit until the loan had matured into a better condition.

And, once again, if the accountants lay down on their basic job, why, huge excess and folly is going to come inevitably, and that happened here.

The national experience with low-interest starter home loans to what I would call the deserving poor, has been very good. But the minute you pay a bunch of people high commissions to make loans to the undeserving poor, or the overstretched rich, you can get loan losses that are staggering.

And I don’t see how the people did it and still shaved in the morning, because looking back at them was a face that was evil and stupid.

WARREN BUFFETT: Yeah. (Applause)

WARREN BUFFETT: You’ve seen some very interesting figures in the last few months on the number — on the percentage — of loans where people didn’t even make the first or second payment. And there’s really — that shouldn’t happen.

That happened, incidentally — you had a prelude to this in the manufactured housing industry.

I mean, in the late 1990s — and securitization accentuated the problem, because once you had somebody in Grand Island, Nebraska, selling a mobile home — or a manufactured home — to someone and they needed a $3,000 down payment and the salesman was going to get a $6,000 commission, believe me, you start getting some very strange things going on.

Now, if the person doing that had to borrow the money in Grand Island, the chances are the local banker would have seen what was happening and said, you know, we don’t want any of this where the salesman fakes the down payment and all that.

But once you just package those things and securitize them so they get sold through major investment banking houses and sliced up in various tranches and so on, you know, the old — the discipline leaves the system.

And securitization really accentuates that, and we have had that in subprime loans, just as we had it in manufactured housing six or seven years ago.

And, like I say, that has not all worked its way through the system, but I don’t think it’s going to cause huge troubles.

Now, we do see certain areas of the country where it will be at least a couple of years before real estate recovers.

I mean, the overhang is huge compared to normal monthly volume in certain sections. And the people that were counting on flipping things there are going to get flipped, but in a different way.