Wall Street Confidential

Buffet's Darker Side

January 30,2008

by Edward Jay Epstein

In the Presidential debates in October, both Barack Obama and John McCain, came up with the same name to save the reeling American economy: Warren Buffet, the 78 year old chairman and largest stockholder of Berkshire-Hathaway, a $120 billion holding company. Known in the media  as the “Oracle Of Omaha,” he had condemned derivative contracts as early as 2003, describing them “as time bombs, both for the parties that deal in them and the economic system.” After derivative contracts on sub-prime mortgages had delivered a near death blow to the financial system in October 2008, he told Charlie Rose in an hour-long televised interview that such derivatives were nothing short of “financial weapons of mass destruction,” saying, “They destroyed AIG. They certainly contributed to the destruction of Bear Sterns and Lehman.” It light of his lucid explanation of their incredible perils, it seemed gratuitous for Charlie Rose to then ask Buffet if he himself had trafficked in derivatives, If he had asked, the Buffet’s answer might have been surprising since, at the time of that interview, Buffet’s holding company not only had multi-billion dollar positions in derivative contracts but it was the largest single shareholder in one of the principal enablers of the proliferation of sub-prime mortgage derivatives.
As subsequently revealed in Berkshire Hathaway’s third quarter 10-K filing with the SEC in 2008, the Oracle turned out to be one of America’s largest seller of derivative contracts. Not only had he sold over $2.5 billion worth of credit default swaps in 2008– the same notorious derivative contracts that had brought AIG to its knees– but he had sold over $6.7 billion worth of another type derivatives, called “index put option contracts” that essentially bet stock prices would not fall here and abroad. These contracts have a duration of as long as 20 year, and, as the disclosure notes, “generally may not be terminated or fully settled before the expiration dates and therefore the ultimate amount of cash basis gains or losses may not be known for years.” Even for the first nine months of 2008, Berkshire’s losses from these derivative already were $2.2 billion.
But Buffet’s involvement in the derivative casino went beyond selling credit default swaps and put options. After Moody’s Corporation, the second- largest credit-rating company, went public in 2000, he had Berkshire Hathaway buy 48 million shares in it– approximately a twenty percent stake– making it by far Moody’s largest shareholder. The role Moody’s was to play in the proliferation of sub-prime mortgage , along with that of the two other rating agencies, Standard & Poor’s and Fitch Ratings, is lucidly described by Nobel laureate economist Joseph Stiglitz in an interview with Bloomberg News: “I view the ratings agencies as one of the key culprits, They were the party that performed that alchemy that converted the securities from F- rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.''
The sad history of Moody’s race to the bottom began after it was spun off by Dun & Bradstreet Corp. in September 2000 and after Buffet had invested $499 million in it. Prior to that, Moody’s was a stodgy company in the low-profit business of evaluating credit data supplied to it largely by triple-A companies. The SEC had given it, along with S&P and Fitch’s, an effective lock on the issuance of credit ratings. So the giant corporations needed to get its top rating (AAA, meaning little or no risk) in order to sell their bonds to insurance companies, pension funds, and other regulated institutions. But with the mushrooming of mortgage-back securities, Moody's found a much more profitable business line: rating pools of mortgages called Collateralized Debt Obligations (CDOs). Working on the theory that if these CDOs were structured into different tiers, it could award Triple A ratings to the safer tiers, which, in turn, would allow underwriters to sell CDOs to institutions, Moody’s made additional money advising the underwriters how to structure their CDOs in such a way so that it could provide top ratings. Once they received these ratings they could leveraged them over and over again via so called “piggy back” loans.
Even though sub-prime mortgages accounted for about half of the collateral on CDOs, Moody's manage through this theory to assign triple A grades to nearly 75 percent of them. In August 2004, to get an even larger share of this business, it revamped its credit-rating formula in such a way that it could issue top-ratings to even a larger portion of sub-prime debt. Not to lose market share, Its chief competitor, S&P, followed suit the next week. By 2006, the market for rated CDOs had exceeded $3 trillion.
This enterprise entailed an obvious conflict of interest since Moody’s was being paid by very companies it was rating, but the profits were so enormous it was overlooked by everyone involved. By extracting almost three times the fees on structured CDOs than it got on conventional corporate debt, Moody’s took in an incredible $3 billion between 2002 and 2006. And since it had operating margins above 50 percent on its rating work, most of this new found El Dorado was profit. When Moody’s stock soared, it increased the market value of Buffet’s stake from $499 million in 2001 to $3.2 billion in February 2007. The Oracle of Omaha thus made $2.7 billion profit from the very “time bombs” he was at the time public ally damning. Moody’s ratings meanwhile enabled these derivatives to spread like kudzu throughout the global financial pipelines until the entire house of cards collapsed in 2008. Moody's then had to downgrade more than 90 percent of all asset-backed CDO investments issued in 2006 and 2007, and Buffet, alas, lost a good part of the windfall
It is hardly conceivable that Buffet, who famously prides himself on the scrutiny he gives to companies in which he invests, could not have known that the heart of Moody’s money machine was certifying hundreds of billion dollars worth of CDOs for purchase by banks and other institution. If he didn't’t know that, what kind of Oracle is he?