2010: What are your thoughts on the SEC’s lawsuit against Goldman Sachs?

CAROL LOOMIS: Warren and Charlie may be smart enough to have guessed that the first question will be about topic A, which is Goldman Sachs.

And I received several emails about the SEC’s lawsuit against Goldman, all of them asking a different question about that problem.

I have combined the several thoughts in these questions, and with thanks to Greg Firman (PH), Kai Pan (PH) of Morgan Stanley, Brian Chan (PH), and Vic Timono (PH), here is the question:

Warren, every year in the Berkshire movie, you did it again today, you use the clip from the Salomon crisis in which you tell Congress that you have warned Salomon’s employees that if they lose a shred of the firm’s reputation, you will be ruthless in your reaction.

Clearly, Goldman Sachs has lost reputation because of the SEC’s action. Could you tell us your reaction to the lawsuit, your reflections in light of it about Berkshire’s large investment in Goldman?

And what advice, in light of your own Salomon experience, you would give Goldman’s board of directors and management?

WARREN BUFFETT: OK. Anytime you ask me these multiple questions, I may go back to you to get all parts.

But, well, let’s start with the transaction, because that’s the important thing.

A few weeks ago on a Friday, a transaction described as ABACUS was made the subject of an SEC complaint. I think it ran about 22 pages. And I think there’s been probably sort of misreporting, not intentional obviously, but misreporting of the nature of that transaction in at least — probably a majority of the accounts that I’ve read about it.

So, I would like — this will take a little time, but I think it’s an important subject. I would like to go through that transaction first. And then we’ll get further into the questions posed by the people that emailed Carol.

The transaction, the ABACUS transaction, there were four losers in, but we’re going to focus on two of them.

Goldman itself was a loser. They didn’t intend to be a loser, I’m sure. They couldn’t sell the piece — a piece of the transaction — and they kept it, and I think they lost 90 or $100 million because they kept it.

But the main loser, in terms of actual cash out, was a very large bank in Europe named ABN AMRO, which subsequently became part of the Royal Bank of Scotland.

Now, what did ABN AMRO — why did they lose money? They lost money because they, in effect, guaranteed the credit of another company, ACA.

ABN AMRO was in the business of judging credits, deciding what credits they would accept themselves, what credits they would guarantee.

And in effect, they did something in the insurance world called fronting a transaction, which really means guaranteeing the credit of another party.

We have done that many times at Berkshire. We get paid for it. And people do not want the credit of the XYZ insurance company but they say they’ll take a policy from XYZ if we guarantee it. And Berkshire has made a lot of money guaranteeing things over the years.

And Charlie can remember back to the early 1970s when we ran into some very dishonest people and we lost money, and we lost a fair amount of money at that time, because we guaranteed the credit of somebody that turned out to be not so good.

It happened to be some syndicates at Lloyd’s, of all things. But they found ways not to pay when our name was on it.

So ABN AMRO agreed to guarantee about $900 million of the credit of a company called ACA. They got paid for that, and this is in the SEC complaint. It’s not mentioned very often, but they got paid, what, 17 basis points, that’s 17/100 of 1 percent.

So they took on a $900 million risk of guaranteeing credit. They got paid about a million-six. And the company whose credit they guaranteed went broke, and so they had to pay the 900 million. It’s a little hard for me to get terribly sympathetic with the fact that a bank made a dumb credit deal.

But let’s look at ACA, because they were sort of the nub of the transaction.

ACA, and you wouldn’t really know this by reading most press accounts, ACA was a bond insurer. Now, they started out as a municipal bond insurer. They guaranteed various credits and they were like Ambac, they were like MBIA, they were like FGIC, they were like FSA.

And all of those companies — and we wrote about this a few years ago in the report — all of those companies started out insuring municipal bonds. Some of them started 30 years ago. And there was a big business in insuring municipal bonds.

And then the profit margins started getting squeezed in the municipal bond business. So what did they do? Instead of sticking to the business they knew and accepting lower profits, they went out and got into the business of insuring structured credits and all kinds of different other deals.

I described their activities a couple years in the annual report as being a little bit like Mae West who said, “I was Snow White but I drifted.” (Laughter)

These bond insurers — and almost all of them did it — these bond insurers drifted into insuring things they didn’t understand quite as well but where they could make a little more money.

ACA did it, MBIA did it, AMBEC did it, FGIC did it, FSA did it, and they all got into trouble, every one of them.

Now, is there anything wrong with a bond insurer insuring structured credit or something other than municipals? No. But you better know what you’re doing.

Now, interestingly enough, Berkshire Hathaway, when these other guys got into trouble, went into the municipal bond insurance business.

And we insured things that were almost identical to what ACA or others had insured, the difference being that we thought we knew more about what we were doing. We got paid better than they got paid, and we stayed away from things we didn’t understand.

We never insured a CDO; we never insured any kind of a RMBS deal or anything of the sort.

But I want to give you an example of something we did insure, because I think it will help you understand better this ABACUS transaction. So if the — if the projectionist would put up slide number 1, I’m going to describe a deal to you.

And as you — as you look at this — is it up there yet? Yeah. Somebody came to us a couple of years ago. I’ll tell you the name a little later. But a large investment bank came to us a couple of years ago.

Now, we were insuring bonds regularly. We insured bonds here of the Omaha Public Power District that’s familiar to many of you. We insured the bonds of the Nebraska — of the Methodist Hospital, which is six or seven miles from here.

We have told people that if the Nebraska Methodist Hospital does not pay its bonds, Berkshire Hathaway will pay them. And we’ve done that to the tune of about $100 million in their case. So we are in the business of insuring bonds.

Now, a couple of years ago, somebody came to us, large investment bank, and they said, “Take a look at this portfolio.”

And as you can see, it’s got the names of a whole bunch of states. Yeah, it’s up there. And very different amounts. It’s got a billion-one for Florida; it’s only got 200 million for the State of California.

And they said to us, “Will you insure these states, that these bonds of these states, will pay for the next 10 years? If any of the states don’t pay, you have to pay as the insurer.”

And I looked at the list, Ajit Jain looked at the list, and we had to decide, A) whether we knew enough to insure them, and B) what premium we would charge, because that’s what we’re in the business for.

And we don’t have to insure them. We can say, “Forget it. We don’t know enough to make the decision.” But we made the decision and we offered to insure those bonds for about $160 million for 10 years.

So we collected a premium of a little over 160 million, and somebody on the other side, the counterparty they call it, somebody on the other side, for 10 years, gets an assurance that, if these states don’t pay, we will pay as if they did pay.

And this gets to the crux of the SEC’s case — or complaint — in respect to Goldman. Somebody came to us with this list; we didn’t dream up the list. Another party came to us.

Now, there’s about four possibilities. Now I’ll tell you who the party was that came to us two years ago: It was Lehman Brothers. So Lehman Brothers, there’s four possibilities, roughly.

Lehman Brothers might own these bonds and want protection against the credit. They might just be negative on the bond market and, in effect, be shorting these bonds and using this method as a way of shorting it.

They might have a customer that owned these bonds who wanted to buy protection against the credit.

Or they might have a customer who was negative on these bonds and was simply wanting to short it.

We don’t care which scenario exists. It’s our job to evaluate the risk of the bonds and to determine the proper premium.

If they told me Ben Bernanke was on the other side of the trade, it wouldn’t make any difference to me.

If I have to care about who’s on the other side of the trade, I should not be insuring bonds. They could have told me Charlie was on the other side of the trade. (Laughs)

So, in effect, we did with these bonds exactly what ACA did with the bonds that were presented to them.

Now, ACA said, with the list of 120 that was presented to them, they said, “There’s about 50 of these that we’re willing to insure.”

And then they went back and negotiated and took on 30 more of them.

We could have said, presumably, “We don’t like Texas that well at a billion-150, and we’d rather have you give us more Floridas,” or something like that.

We didn’t do it. We just took the list that was submitted. So it was totally the other guy’s list that we insured.

In the case of the ABACUS transaction, it was sort of a mutual — a negotiation — as to which bonds were included.

Now, in the end, the bonds that were included in the ABACUS transaction all went south very quickly.

That wasn’t quite so obvious they were going to do that in early 2007, as you could see by studying something called the ABX Index.

But the housing bubble — really, mania — started blowing up in 2007.

Now, there could be troubles in these states that we insured. You can say they have big pension obligations, and maybe the guy who’s shorting them on the other side knows more about that than we do, but, you know, that is our problem.

I mean, if we want to insure bonds, in the case of ACA, in the case of MBIA, they have teams of people do it. We just do it with a couple people at Berkshire.

But I see nothing whatsoever — I mean, if we lose a lot of money on these bonds, I am not going to go to the guy on the other side of the transaction and say, “Gee, you took advantage of me.”

I don’t care if John Paulson is shorting these bonds to me. He has no worries that I’m going to claim that he had superior knowledge about the finances of these states or anything of the sort.

So that was basically the ABACUS transaction. I think the central part of the argument is that Paulson knew more about the bonds than the bond insurer did.

My guess is the bond insurer employed more people than John Paulson did in his business, and they just made — they made what turned out, in retrospect, to be a dumb insurance decision.

And for the life of me, I don’t see whether it makes any difference whether it was John Paulson on the other side of the deal, or whether it was Goldman Sachs on the other side of the deal, or whether it was Berkshire Hathaway on the other side of the deal.

Let’s say we had decided to short the housing market in some way in early 2007. I don’t think anybody should blame us for taking our position if we did it. We didn’t do it. Or if we’d taken the long side.

I think before we get to the other part of Carol’s questions, I’d ask Charlie to comment as this as Charlie has a law degree, and in other ways is superior to me, so we’ll get his views.

CHARLIE MUNGER: Well, my attitude is quite simple. This was a three-to-two decision by the SEC commissioners under circumstances where they normally act unanimously.

If I had been on the SEC, I would have voted with the minority two and not with the three who authorized the lawsuit.

WARREN BUFFETT: Carol, would you get to the three parts that we probably haven’t answered yet? And then I’ll tackle this one.

But I really feel it’s important to understand the transaction. I have not seen — I have seen ACA referred to as an investor. It’s true that ACA had a management company, but it was 100 percent owned by ACA.

ACA was a bond insurer, pure and simple. And they had this — very simple, as it turned out — and they had one part of the organization did this and that. But ACA lost money because they were a bond insurer.

Yep, Carol?

CAROL LOOMIS: Well, I’m assuming that you have covered the part that says could you tell us your reaction to the lawsuit. So the next part was your reflections, in light of it, about Berkshire’s large investment in Goldman.

And then the third was what advice you would have, given your Salomon experience and the thread of reputation that you have planted, those words you have planted. Those are the last two parts.

WARREN BUFFETT: Ironically, very ironically, it’s probably helped our investment in Goldman in a certain way, because we have a $5 billion preferred stock that pays us $500 million a year.

Goldman has the right, the legal right, to call that at 110 percent of par. So anytime they want to, they can sent Berkshire 5 1/2 billion, and they get rid of this preferred stock which is costing them 500 million a year.

If we got that 5 1/2 billion in, immediately we’d put it in very short-term securities, which probably, under today’s conditions, might produce 20 million a year or something like that.

So every day that goes by that Goldman does not call our preferred is money in the bank. It’s been pointed out that our preferred is paying us $15 a second. So as we sit here, tick — (laughter) — tick, tick, tick, that’s $15 every tick. (Applause)

I don’t want those ticks to go away. (Laughs)

I just love them. They go on at night when I sleep — (laughter) — on weekends.

And frankly, Goldman would love to get rid of that preferred. I mean, they only agreed to sell us that preferred because it was sort of at the height of the crisis.

The U.S., I’m not sure what part of the government, probably the Fed, but they have been telling companies that took TARP money whether they could increase their dividends or not, whether they could redeem preferred, and all that.

Up till now, probably the Federal Government has been doing us a big favor by telling — even before this thing happened — they’ve probably been telling Goldman that, “You can’t call that preferred until we tell you you can. And you can’t increase your dividend.”

They’ve been pretty strong with all of the TARP companies. That has not been publicized too much, but believe me that it’s the case.

So I was just sitting here hoping that the — basically, that the Fed, or whomever, would be — continue to be — quite tough, in terms of letting Goldman call our preferred. But it wasn’t going to go on forever.

I think that — I think recent developments have probably delayed the calling of our preferred by some time so the tick, tick, tick — (laughter) — will go on, and we will be getting $500 million a year instead of $20 million a year.

We love the investment, and I would expect that — the question about losing reputation.

There’s no question that the allegation alone causes the company to lose reputation, and obviously the press of the past few weeks, they hurt. They hurt a company. They can hurt morale, a lot of things. Nothing — it’s not remotely mortal or anything like that, but it hurts.

Incidentally, Goldman Sachs had a situation in connection with the Penn Central, 30 — 40 years ago now. And that hurt at that time.

They had a connection with one fellow in terms of Boesky that hurt at that time. And it was the source of great pain to John Weinberg, who was running Goldman.

But I don’t believe that the allegation of something falls within my category of losing reputation. If something is proven, then you have to look at it.

My advice, in times of some kind of an emergent — when some transgression is either found or alleged, you know, basically, you saw Ron Olson in our movie, he was the manager of the team.

And back when we were working at Salomon together in a somewhat similar situation, we had as our motto, “Get it right. Get it fast. Get it out. Get it over.”

But, “Get it right,” was number one. I mean, you have to have your facts right, because if you go out with the wrong facts you get killed, and you can’t redo it afterwards.

But that does mean sometimes some delay. You have to gather information from within your own organization, and you are on the defensive.

I would not — I do not hold against Goldman at all the fact that an allegation has been made by the SEC. And if it leads into something more serious, you know, then we’ll look at the situation at that time.

But what I’ve seen in terms of the ABACUS activity, I just don’t — I do not see that that would be any different than me complaining about the list of municipals that were given to me to insure a couple of years ago.

Charlie?

CHARLIE MUNGER: Well, I agree with all of that. But I also think that every business ought to decline a lot of business that’s perfectly legal and proper to accept.

In other words, the standards in business should not be what’s legal and convenient. The standards should be different.

And I don’t think there’s an investment bank in America of any consequence that didn’t take too many scuzzy customers and deal in too many scuzzy securities.

WARREN BUFFETT: I would agree with that. But, Charlie — (applause) — do you think we should have done our municipal bond deal?

CHARLIE MUNGER: I think it was a closer case than you do.

WARREN BUFFETT: (Laughs) OK.

We insure, probably, 40 billion now, or something like that, of municipal bonds. And we have done very little in the last year, not because of Charlie’s views that he just expressed, but basically because the price isn’t right, the premiums are wrong.

And the reaction of other people when premiums are wrong is to take more risk. And our reaction when premiums are wrong is just to go play golf or something and tell somebody to call us when premiums get right again.

I do want to — Charlie and I will give our views on a lot of the activities that have gone on on Wall Street, and we do think plenty has been wrong.

I do want to point out, though, that our experience with Goldman goes back 44 years. And during those years, we’ve bought more businesses through them than through any other Wall Street investment bank. We’ve probably done more financing.

They have helped build Berkshire Hathaway. And we trade with them as well.

We don’t hire them as investment advisors. They have a big investment advisory business, and, you know, our reaction to that is, “No, thanks.” You know, we are in the business of making our own decisions.

But when we trade with them, they can very well be shorting to us a stock we’re buying. You know, they can be buying for their own account some stock we’re selling.

They do not owe us a divulgence of their position any more than we need to explain to them our reasoning or what we are doing in our position.

We are acting there in a non-fiduciary capacity, and they are operating in a non-fiduciary capacity, in my view, when they are trading with us.

Now, if they’re working on our behalf on an acquisition or a financing, that’s a different story.

But I would say that we have had a lot of very satisfactory transactions with Goldman Sachs.

And I don’t want to prolong this. I won’t do this on any more questions. But I’d like to — some people here will remember this — I’d like to take you back to the very first bond issue that Charlie and I ever did.

This was our maiden voyage back in 1967, I believe. Yeah. And if we could put slide 2 up there, I will direct your attention to the —

This is an offering that was made in 1967. We’d just bought a department store and we had a company called Diversified Retailing. Now, Diversified Retailing only owned one retailing operation, but we were sort of imaginative in those days, so we called it Diversified Retailing. (Laughter)

And we went out to raise $5 1/2 million. And Charlie Heider of Omaha, whom many of you know, helped me in the financing.

And you will notice our tombstone ad there has on the top two lines “New York Securities” and “First Nebraska Securities.”

They were the lead underwriters. And as customary with tombstones, there are a group of underwriters listed below, and they’re usually listed in the degree of their participation.

In other words, the more that they’re involved, the higher up in the list they are, with the lead underwriters on top. And that’s been true of every tombstone I’ve ever seen, except this one.

And what happened in this one was that we were having trouble raising $5 1/2 million. And I called Gus Levy of Goldman Sachs, and I called Al Gordon of Kidder Peabody. Those were two of the most prestigious firms in Wall Street at the time.

And I said, “Would you guys help me? We’re trying to raise 5 1/2 million and there’s nobody that wants to give Charlie and me 5 1/2 million. And the underwriters we’ve lined up are having trouble getting it done.” And both Gus Levy and Al Gordon said to me, “Warren, we’ll take a big piece.”

And if you’ll put — if you put up slide number 3, you will see the list of underwriters, and Goldman Sachs highlighted and Kidder Peabody highlighted were actually the next-largest underwriters. But they were so ashamed of being associated with our dinky little company that they asked us to leave their names off. (Laughter)

They wanted to give us money under an assumed name. (Laughter)

But they did — they did come through for us. They did come through for us. And believe me, a lot of people weren’t coming through for us then. I do have a long memory for people that have taken good care of Berkshire over time.

And Al Gordon died last year at the age of 107. He worked until he was 104. He was a remarkable man. Gus Levy was a remarkable man. And I thank them for their participation, even though they did want to do it under an assumed name. (Laughter)