2008: How will Berkshire take advantage of the current market dislocations?

AUDIENCE MEMBER: Dear Mr. Buffett, dear Mr. Munger. My name is Oliver Krautscheid from Frankfurt in Germany.

The subprime crisis has led to inconsistent pricing in capital markets. Credits are trading at large discounts, and at the same time, the equities do not reflect this.

My question is, when will this be over, and how do you take advantage of market dislocations?

WARREN BUFFETT: Well, when there are market dislocations, there are always ways to take advantage of it, but we’ll leave for you the joy of searching for those.

But there have been some really important dislocations. And I brought along, just for your amusement, a few figures on something that we’ve done recently. But it doesn’t have any big significance for Berkshire. I mean, Berkshire will make some extra money out of this.

It doesn’t take any time to think about. But it does illustrate just how dramatic the changes were. And the ones I brought along relate to the tax-exempt money market funds.

There were 330 billion of these. That’s a lot of money — 330 billion. And they relied on repricing of — really, in almost all cases — first-grade municipal bonds.

Every seven days they have these auctions, and it was all set up very elaborately so that people could have their money, more or less, in their minds, instantly available and something that was tax exempt, and they were marketed extensively.

And I brought along — for example, here’s one that related to the — they were backed by various municipal issues. This one happens to be one by the LA County Museum of Art. Just pulled that out.

And on January 24, it was marketed at 3.15 percent; January 31, 4.0; February 7, 3.5; February 14, 8 percent.

Now, how can a tax-exempt bond of short-term nature be selling at a 3 1/2 percent rate one week, and one week later on Valentine’s Day be at 8 percent, and one week after that be at 10 percent?

It’s now back to 4.2 percent. Now, those are huge dislocations in markets. That’s crazy.

It would be one thing to be some little obscure item, but this happened with billions and billions and billions of dollars of securities.

It even happened — we get these bid sheets every day, and this happens to be a bid sheet, I think, from Citigroup. And they were repricing these every seven days.

And what you would find on these — you’ll see there’s lots of issues involved — the same issue would appear on several different pages, because it would represent some different auction, although handled by the same broker at the same time.

On one page you would find an issue — we would bid all these — we happened to bid these at 11.3 percent.

On one page, we bought them at 11.3 percent. On another page, the same issue, we bid the 11.3 percent and somebody else bid 6 percent.

So you have the same issue with the same broker at the same time being sold at 11.3 percent and 6 percent. Those are marks of extreme dislocation, and you find those occasionally.

You found that after the Long-Term Capital Management crisis is 1998. You found the equivalent of it in the stock market in 1974, and so on.

And those are great times to make unusual amounts of money. And if you — there’s certain things we can’t figure out.

I see — in the Wall Street Journal — I see advertisements these days of auctions taking place in some esoteric mortgage securities. If you had enough time, you could probably figure out some of those that were very mispriced. We don’t fool around with that. We just don’t have the time.

We were able to do four — we have about 4 billion in this right now. When we get all through, we’ll have made some extra money for a couple of months.

It won’t be significant, in relation to Berkshire’s size, but it’s something that’s very easy to do.

You may be able to find — by working very, very hard on some smaller issues — you might be able to find in this mess in mortgages — and it’s gone beyond subprime. It’s gone into Alt-As and it’s gone into Option ARMs and that sort of thing.

There very well could be some great opportunities out there that Charlie and I will no longer spot because we just can’t be looking at that many things.

Charlie?

CHARLIE MUNGER: Yeah. What is interesting is that — how brief these opportunities to take advantage of dislocations frequently are.

Some idiot hedge fund bought unlimited municipal bonds at, you know, incredible margins. I think they bought 20 times more municipal bonds than they could afford with their own money, borrowing all the rest.

And when those things were dumped on margin calls, municipal bonds suddenly got mispriced in America. But the dislocation was very brief. So you —

WARREN BUFFETT: But very extreme.

CHARLIE MUNGER: But very extreme.

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: So if you can’t think fast and act resolutely, it does you no good.

So you’re like a man standing by a stream trying to spear a fish and the fish just comes by once a week or once a month or once every ten years. And you’ve got to be there to throw that spear fast before the fish swims on. It’s a pretty demanding business if you do it right.

WARREN BUFFETT: But there have been times. I mean, in the junk bond market, there was a three- or four-month period in 2002 where some really incredible things happened and they happened on a large scale. So —

CHARLIE MUNGER: Yeah. It happens about twice a century.

WARREN BUFFETT: Yeah. (Laughter)

Which means he and I have only had four or five times when we could do it. (Laughter)