2015: What's the moral case for practices at Clayton Homes and 3G?

CAROIL LOOMIS: So, my first question is from a man in Timpson, Texas, who happens to have a familiar name, Frank Gifford, but wants to make it clear that he isn’t the football Frank Gifford, but rather a travel photographer.

And his question is a hard one. He says, “I’ve been a shareholder for 15 years, but I’m now suffering heartburn. Until recently I considered Berkshire an ethical company, benefiting society through” — and here he mentions two Berkshire companies headquartered in his home state — he says, ”— through BNSF and ACME Brick.

“Two points call that opinion into question now: One is the Seattle Times story on predatory practices at our Clayton Homes subsidiary.

“Clayton mainly responded with platitudes to this article and would not answer questions, so I have to assume the facts in the story are correct.

“The other point that I want to mention is our growing partnership with 3G Capital. I sold my Tim Horton stock in disgust before 3G gutted 20 percent of the corporate staff and plunged this well-run company deep into junk territory.

“Other takeovers 3G has made have been still more brutal.

“You and Charlie have made many statements about upholding Berkshire’s reputation, and you have avoided anti-social investments like tobacco and gambling.

“Your efforts years ago to keep Berkshire’s textile mills running show you once aspired to balance capitalism with compassion.

“I cannot make the moral case for practices at either Clayton or 3G, and I wonder how you can do so.”

WARREN BUFFETT: OK. Let’s talk first about the Clayton article because there was some important mistakes in that, but I think it’s first — it’s better to back up even to the situation in mortgage lending that’s taken place, and why Clayton follows a pattern that, actually, is exemplary and rather extraordinary, in the home building and mortgage business.

If you look back at the housing bubble in — well, ending more or less in 2008, one of the great problems, in fact, maybe the greatest cause, was the fact that the mortgage holder became totally divorced from the mortgage originator and from the home builder.

In other words, the home builder built a house and sold it, took his profit, and that was that. It didn’t really make much difference who he sold it to.

And the mortgage originator would originate a mortgage but then package those, securitize them, and often sell them around — even around the world — so people thousands and thousands of miles had no connection with the original transaction.

And the mortgage originator suffered no loss if the loan went bad.

So we had these two parties: the one that connected with the home buyer, and the one that originated the mortgage, and they had no connection with the actual outcome of whether it was a good mortgage or not.

At Clayton, unlike virtually anybody — there’s a few — we offer the — we offer mortgages to all the buyers of our homes. And we have retained roughly 12 billion of mortgages on 300,000 homes.

Now, when a mortgage goes bad, two people lose: the person that owns the house loses, and the person that owns the mortgage loses.

And in our case, we have this identity of interest. We have no interest in selling anybody a house, and having that mortgage default, because it is a net loss to us. It is a net loss to the customer.

And like I say, that’s not true of most home builders. It’s not true of most mortgage originators.

So you — and there’s been much talk, in terms of possible changes in mortgage rules, to try and get the mortgage originator to keep some skin in the game. And they’ve talked about them retaining maybe 3 percent of the mortgage or something like that, just so they would have an interest in, really, what kind of a mortgage they were putting on the books.

Well, we keep — in many cases — we offer to everybody, but we keep — probably in half the cases, we keep 100 percent of the mortgage, so we have exactly the same interest as society has, and as the home buyer has, in not making mortgage loans to people who are going to get in trouble on those loans.

Now, it’s true that manufactured housing hits the lower end of the market, in terms of house values. Of the homes selling for $150,000 — new homes selling for $150,000 or less — 70 percent of them are manufactured houses.

And some of those people — most — many — of those people do not qualify, on a FICO score, to obtain loans that are government guaranteed. Some do, but most don’t.

And the question is: can you lend intelligently to people who have a good chance of making the payments, keeping that house?

And Clayton has been exemplary in doing that. About 3 percent of the mortgages default in a year, you know, and when they do, we lose money and the person who bought the house loses money.

But 97 percent don’t, and most of those people would not be living in the kind of houses that you can see right here at the auditorium, without the financing availabilities that Clayton makes available, and others make available.

And I invite you to go out and look at that house for $69,500. That house will be transported and erected, ready to go — you have to have the land and that — and I’ll get to that in a second — but for 69,500, you have that house with appliances, with air-conditioning, with a couple bedrooms, 1200 square feet. And probably you’ll put another 25,000 or so in the house, but — in terms of the land and preparation there — so maybe it will be $95,000.

But I just — you know, you can make your own judgment as to whether that’s a decent value. And I know most of you are not living in $95,000 homes, but there are an awful lot of people that aspire to do that.

And we help them, with our own money at risk, to move into those homes. And if we make a mistake, it hurts them and it hurts us. And that is a very unusual arrangement in the financial industry.

Now, I read that story, and in it, there was an item in it, which, reading through the story, I just knew wasn’t true. I mean, nobody that knew anything about manufactured housing could have put that up.

I’d like to put that up on the slide, where it says, “Another Clayton executive said in a 2012 affidavit that the average profit margin on Clayton homes sold in Arkansas between 2006 and 2009 was 11,170 — roughly 1/5 of the average sales price of the homes.”

So this fellow is quoting somebody as saying that we’re making a 20 percent profit on home sales.

Well, I knew that that was nonsense, so I asked for the affidavit. And I read the affidavit about three times, and nowhere in that affidavit was it — was this statement made.

Now, what was said was what I’ll show in the next slide. It’s hard for me to see what’s up there, but it should show Item 6, where it says Clayton Manufactured Homes sold 2,201 homes, and Item 7, that four percent of the gross profit from the home sales totaled 983,000.

So if we’ll move to the next slide. I did a little arithmetic and, sure enough, if you take 25 times the commission for — the commission is 4 percent, so you take 25 times — and then you divide by the number of homes, you come up with 11,170.

But, that statement in the affidavit said gross profit, and gross profit is not the same thing as profit. I’m not sure that the fellow that wrote the story understood that.

So I have put on the next page the difference, for example, of a couple other retailers. I put Macy’s and Target.

And Macy’s has a 40 percent gross profit margin, but a pretax margin of 8 1/2 percent, after taxes of 5.4.

Gross profit is what you — if it’s the case of Macy’s, what they pay for a sofa or something, and what they sell it for. But they also have the expenses of paying salespeople, rent, utilities, advertising, all kinds of other things.

So the idea that gross profit and net profit are the same thing is — you know — anybody that understands accounting would never make a mistake like that.

In our particular case, on the next page, our gross margin is what the fellow said in the affidavit, and he used the word “gross,” of 20 percent. But the writer of the story turned that into a profit margin, and our profit margin is actually three percent. So I’d just like to point out the mathematics on that particular subject.

There’s one other item you should see — and, again, I have trouble seeing the — what’s up there — but we have a — in every retail Clayton establishment, we have a lender board which shows exactly what a variety of lenders are willing to do and what their terms are.

And we also have a sheet, which I think will be put up there, and it’s less than a full page, and it sets out the lenders who are available.

And at the very top — I’m just looking to see whether I can find that right here — at the very top of it, it basically says, you know, check out more than one lender, and you can send the application to any of these people. And we have people sign at the bottom, and there’s no small print on it. I can’t see it here, but — it may look like small print — but it’s one page, and multiple lenders are put on that sheet.

Sometimes people borrow — if there’s a credit union in San Antonio that’s very big, the local bank is very big, and we also will lend money to the buyer of the home, if they wish.

If you buy that home that’s out there, we’ll give you a list of four or five lenders, probably including your local bank, and you will probably take the loan that offers you the best terms.

So, I make no apologies whatsoever about Clayton’s lending terms.

I get letters from people complaining about our subsidiaries in various ways. I mean, some people call the office, some people write in. I can say, in the last three years I have not received one call — we’ve got 300,000 loans — I’ve not received one call from any party in connection with a Clayton Home.

Moreover, we are — at Clayton — we are regulated in almost every state — every state in which we have financing, which is practically every state.

And in the last three years, we have had — I think its 91 examinations by the state, 91 examinations.

They come in. They look at our practices. They make sure that they conform with the laws.

And in those 91, we — I think the largest fine we’ve had has been $5,500, and the largest group of refunds we had was about $110,000.

Yeah, there were — and, you know, those were regulated, not only by those states, were regulated by HUD, all kinds of people.

When we can, we try to get people an FHA loan, because that’s the best loan for them to get.

But, as I say, most of our borrowers are below the 620 FICO score. And it’s true that three percent or so will lose their homes in a year. It’s true that 97 percent of those people will have a home where their average principal and interest payment is a little under $600 a month, and that takes care of having a two- and perhaps three-bedroom house, well equipped. I invite you to go through it.

And Clayton has behaved, in my book, extraordinarily well.

The article talked about 30-year mortgages. Over 4 1/2 years ago, I said we’re not going to have 30-year mortgages. So we don’t have them, except for the FHA-guaranteed ones, which, of course, have a very low rate.

So I have no — I’m proud of the Clayton management. I’m proud of the fact they put, this year, maybe 30,000 people in homes at a very low cost, a very good home. And a very high percentage of those people are going to have those loans paid off, probably in 20 years, and have a home that has cost them — has been a real bargain, basically.

I’ll get to the other question — the 3G question, too — in just a second, but we’ll give Charlie a chance to say what he’d like to.

CHARLIE MUNGER: I don’t know a lot about the mortgage practices at Clayton, but I certainly know that we’ve sold an enormous number of houses and we have a big share of the total market in manufactured.

WARREN BUFFETT: About 50 percent.

CHARLIE MUNGER: Fifty percent.

And it’s a very constructive thing. Personally, I’ve always wondered why manufactured houses don’t have a bigger share of the market. It’s such an efficient way of creating quite usable houses.

Part of the reason is that the track builders, under capitalism, got so efficient. And isn’t Clayton now doing some track building itself?

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: I think so, yes.

So, Clayton is a very productive part of the economy, but we can’t make lending to poor people who buy houses 100 percent successful for everybody. We wouldn’t be running the business right if the foreclosure rate was zero. Too many people would deserve credit that wouldn’t get it.

WARREN BUFFETT: Yeah. The big causes of default are the loss of a job, death, and divorce. And, you know, that happens with high-priced houses as well, but it happens more often with people that are living closer to the edge.

But I don’t think that’s a reason to deny them a house, and particularly when so many — it turns out so well for so many.

The 2008 recession was — and ’9 — was very interesting, because all kinds of securitized deals, involving houses costing hundreds and hundreds of thousands of dollars, the default rate on those was many, many, many times what happened in our own case.

And similarly with delinquency rates. Our delinquency rates are running 3 percent, currently.

And, you know, it — the people want to live in those houses, and I think they deserve the right to.

Incidentally, we had a — a few years ago we had a couple houses here, we called them the “Warren” and the “Charlie.”

The “Charlie” sold first, and it sold to one of the cameramen who was in the credits on the movie you just saw. And you can check with Matt, and he’s — Matt Mason — he is very, very happy with that house he bought four or five years ago.

WARREN BUFFETT: The second question was about 3G, and I don’t think you can ever find a statement that Charlie and I have ever made, in terms of Berkshire’s companies or anybody else’s, where we said that there should be more people working than are needed in a company.

And the 3G people have been successful in building marvelous businesses. And it is true that they have entered into some purchases where there were considerably more people running the business than needed. And the interesting thing is that after they reduced the headcount to the number needed, the companies have done extremely well.

I mean, you’ve seen Burger King outgrow its main competitor by a significant margin. You’ve seen Tim Horton have some very good figures in the first quarter.

And I don’t know of any company that has a policy that says we’re going to have a lot more people than we need. But a good many companies end up in that position, and if 3G buys into one, they quite promptly — and treat people well in terms of the severance — but they get it down to what they need.

And I hope our Berkshire companies are not being run with more people than they need, either. They usually aren’t when we buy them, and, you know, we look for those companies that are well managed.

3G is — will — if they find out that 100 people are doing what 50 people can do, they’ll get it to where 50 people are doing it. And I think that actually makes sense throughout American business. Charlie?

CHARLIE MUNGER: Well, the alternate to the system of having your company right-sized, the right number of people, is what eventually happened in Russia. And there, everybody had a job. And the way it all worked out was some workers said, “Well, they pretend to pay us and we pretend to work,” and the whole damn economy didn’t work. Of course, we want the right number of people in the jobs.

WARREN BUFFETT: It’s interesting. In the railroad business — in the railroad business after World War II, in 1947 or thereabouts — I think there were about 1.6 million people in the railroad business, and it was a lousy business. And capital was short for any kind of improvements.

And now there are less than 200,000. So they’ve gone from a million-six to less than 200,000, carrying more freight, more distance, and doing it in far safer conditions. Safety has improved dramatically in the railroad industry.

And if somebody thinks it would be better to be running the railroads with a million-six, you know, people doing it, you would have a terrible railroad system. You wouldn’t have anything like you have today.

Efficiency is required over time in capitalism, and I really tip my hat to what the 3G people have done.