Friday, May 29, 2009


The SnowBall: Warren Buffett and the Business of Life, by Alice Schroeder, (New York: Bantam Dell Books, 2008), 837 pages, $35.00.

The Snowball begins in 1999 at a Sun Valley conference: an annual series of discussions and seminars. We hear a new term “elephant-bumping,” a quip defined by Buffett as getting big shots together to reassure them they are really big shots. Readers begin by meeting Buffett at retirement age and get the highlights of his conference presentation, where he confronts the big shots with some financial ideas they do not all want to hear.

Following the introduction the book chronicles Buffett’s life and career from the beginning in 1930 through September 2008. His father, Howard Buffett, was a successful stockbroker in depression era Omaha where Buffett grew up delivering papers and collecting stamps. He purchased his first stock in the spring of 1942: 3 shares of Cities Service Preferred.

Buffet graduated from Woodrow Wilson High School in Washington, DC, where he lived and spent most of his time after his father was elected to Congress in November 1942. We hear about his Washington life and go with him for his two years at the University of Pennsylvania, but then back to Nebraska where he finished college at the University of Nebraska.

It is about this time readers get the strongest whiff of the Buffett obsession with money making as a competition in itself. He was turned down at Harvard Business School but gets a special late admission to Columbia to study finance and stock analysis under Benjamin Graham and others well known in Security Analysis.

His business studies at Columbia turned out to be a transition into his lifelong career in investing. By the time he took a job on August 2, 1954 with the Graham-Newman investment partnership in New York he already had considerable knowledge and experience despite his young age of 24.

At Graham-Newman he studied Standard and Poors and Moody’s manual looking for companies his mentor, Ben Graham called Cigar butts. Cigar butts Graham defined as cheap and unloved stocks that had been cast aside like the sticky mashed stub of a stogie left on the sidewalk; a stogie that might have one last free puff.

One example turned out to be a company run as a pubic utility in New Bedford Massachusetts called the Union Street Railway. His review of the company showed it was selling for half the value of its cash in the bank. It was a real cigar butt but there would be more.

After several years Graham and Newman retired and the Graham-Newman partnership was shut down. Buffett decided to form his own partnership, which started May 1, 1956 as Buffett Associates, Ltd. It was set up as an investment partnership based in, and operated from, Omaha, Nebraska and not New York city. He had seven partners.

The author’s discussion of the partnership begins on page 201. The remaining 636 pages describe Buffett’s businesses, his investments and investment strategies over 53 years. We learn about Berkshire-Hathaway, GEICO, Kay Graham and the Washington Post and all his well known and not so well known investments, but there is much more in what is a very long book.

Business principles surface through pithy slogans and aphorisms and sometimes by example. He was one of the first to warn about, and object to, the use of derivatives and other speculations. He got to see how correct he was when he worked to rescue Salomon Brothers and Long Term Capital Management. He avoided leverage and the risk that goes with it. He was never a passive investor, but exerted his influence directly and by finding the right people to manage the companies he acquired.

Buffett sayings: Rule number one, don’t lose money. Rule number two, don’t forget rule number one. Rule number three, don’t go in to debt. There are more rules and principles.

Business issues and career decisions mix through the book with long narrative discussions of family members and their personal lives: relationships, careers and interests. Readers meet many business and personal friends, often with lengthy asides and narrative profiles. Readers go to parties and travel to many places. We learn Warren Buffet has simple tastes and the culinary habits of an eight year old, along with other personal matters.

Direct quotes from the author’s interviews run through the book and they are set in italics, an especially good feature. These interviews help the reader to understand the philosophy and strategies that brought personal and financial success. Extensive quotations from interviews let readers do more of their own interpretation unfiltered by the author.

His political views and social attitudes emerge in both the narrative and quotations. He supported civil rights when it mattered the most and progressive politics generally. He turned into a vocal opponent of the Bush tax policies and especially opposes eliminating the estate tax.

Throughout the book the author kept giving financial progress reports even from Buffett’s early years in Omaha. She wrote now Warren has $120; now Warren has $2 billion; now Warren has $7 billion and so on. It was unnecessary at least for me. I did not read the book to be counting money I wanted to learn something about a man who did something unusual that virtually no one else has ever done.

By the end of the book I felt the success of someone who is patient enough, cautious enough, hard working enough and savvy enough to do something extraordinary that he set out to do, and without losing his ethical compass. In an age of speculative failures where rogues and scoundrels are everywhere that makes him a unique success, at least in my book.

Tuesday, May 26, 2009

Banks and Bailouts

First published on

Banks keep making news. One caption in the April 18th Washington Post reads "Bank Profits Mask Peril Still Lurking." Readers learn the biggest of America's banks like Citigroup and J. P. Morgan Chase are reporting large first quarter profits, but remain pessimistic about their future and the future of the economy.

The Federal government has been bailing out the nation’s banks since last summer, handing out billions in emergency reserves with as many as 500 banks mentioned, always with a press release telling the public there must be bailouts or the banks and economy will collapse.

A collapse of the financial system is more complicated than the government wants to talk about. One type of collapse would occur if banks could not clear checks for their checking account customers. You and I go to pay our phone bill and the check bounces, but it’s not our fault the bank has run out of reserves.

That could be called a calamitous collapse. Technically it could occur because the United States uses a fractional banking system, which means individual banks only hold a fraction of their checking account liabilities as reserves to pay checks. Typically the Federal Reserve requires monetary reserves around 15 percent for checking account liabilities, the rest can go to loans. When customers with checking accounts also make deposits and borrowers make their loan payments 15 percent will be enough.

When borrowers default by the billion, banks will not have reserves to pay on their checking accounts, which signals a collapse of the banking system. Not to worry though because the Federal Reserve bank has the ability and full authority to provide the necessary reserves to America’s banks and they have been doing just that.

Making sure there are reserves for checking account customers could be called an essential and adequate bailout. It is the minimum that must be done to keep payments flowing and prevent an economic collapse.

However, the government is going far beyond that minimum with its bank bailouts. They press billions more of reserves on the banks, telling them to forget about defaulters and go find some more borrowers. In effect, the government wants our banking system to lead America out of recession. It is not working though, at least not so far.

The bank profits mentioned in the article above are coming from more recent loans for spending made with the bailout reserves, but bank officials themselves are saying these loans went to other weak and potentially defaulting borrowers. Many banks, especially large ones, have been doing a large share of their business in credit cards for some time, but wages and employment are in no shape to expect credit card lending to revive the economy.

We need spending to get the economy going, but right we will have to trust the Obama spending plan and not the banks. Banks will follow America out of recession, but there is no sign yet they will lead us where we need to go.

Thursday, May 14, 2009

Henry Ford and Mass Production

First published in the April 24, 2009

Mass production needs mass markets. It’s not a new idea. Back in 1914 Henry Ford opened his Model T auto plant using the assembly-line method; a new invention at the time. To the anger and indignation of the nation’s business community, he offered the unheard of high wage of $5 a day.

Apparently he knew he would be producing more cars than Americans could buy, but the higher wage would help him sell what he could produce. Now, almost a hundred years later, America can produce millions of new cars Americans cannot afford, and the industry Henry Ford founded totters on the brink of bankruptcy.

When a country does not buy what it can produce it will have idle factories and idle workers: a recession as America is having now. Back in the 1930’s during the Great Depression the Roosevelt administration adopted a policy of spending the country out of depression. Having the government borrow and spend comes with worries and conflicts over debt and deficits, but it does pump money into the spending stream and create jobs.

The Roosevelt policy was the start of a great tradition in American politics for both Republicans and Democrats, who always adopt a policy of spending America out of recession. The Obama stimulus plan is in that great tradition. In the current down turn the government plans to spend on many new projects, pumping money into states and communities and leading the way for private sector spending.

The presumption of the stimulus policy is the same as always: government spending is regarded as inferior to private spending and therefore a temporary stimulus until private sector spending takes over. But in the recession of 2009 we may want to remember Henry Ford just to remind ourselves that adequate private sector buying power cannot be assumed.

A policy to spend America back into prosperity needs people and families who return all their money to the spending stream in stable and predictable ways. A married couple supporting themselves as cashiers can be expected to spend all their money on room and board, car loans, gasoline, phone service, clothing and, we hope, a little left over for health care and entertainment.

Cashier is one of America’s two biggest jobs, which are retail salesperson and cashier. Together they make up 8 million jobs, or almost 6 percent of America’s jobs at establishments. The median wage for a cashier reported by the Bureau of Labor Statistics is $17,160, but the 90th percentile wage is still only $24,600. For a couple both earning $24,600 the Federal income and payroll taxes come to $7,656.30, not to mention state income taxes, sales taxes, utility taxes, gas taxes and a few more. Retail sales and cashier are just two jobs, the Bureau of Labor Statistics reports hundreds more with millions employed earning wages no more than cashiers.

The millions who earn low wages and pay high taxes contrast sharply with news of the very rich and news of the growing inequality of income. Corporate heads with bonus and severance packages get millions of dollars. Hedge fund managers get paid in capital gains that have favorably lower tax rates than wages.

Recently the Statistics on Income Division of the IRS published its report on the 400 individual tax returns with the highest adjusted gross incomes. It is for the years 1992 to 2006. For 2006, they report the adjusted gross income for each of the top 400 was an average of $263.3 million dollars. The top 400 taxpayers divvy up a total of $105.3 billion dollars

So often discussion of the rich and the taxes they pay, or don’t pay, starts and ends with what is fair. The rich should pay their “fair share”, whatever that might be. But in a country that expects to spend itself into prosperity, it is worth asking how and when the rich get their billions back into the spending stream?

For the stimulus plan to work any income not spent as consumption, has to make its way back into the economy as loans to borrowers. After all, mass markets need mass production, which means saving has to be turned into loans for projects that support jobs building factories, rapid rail lines, solar panels and other real capital.

Financial intermediaries, formerly known as banks, savings and loans, credit unions, finance companies, mortgage or investment banks and a few more, cumulate the savings of savers in order to make loans to borrowers. They act as intermediaries because they are like agents in the middle of a transaction between savers and borrowers. Their sole function is to channel the savings of net savers back into the spending stream as loans to net borrowers.

There was a time when it was common for borrowers to create long lived assets, but back in the 1980’s adventurous money managers starting having loanable funds to buy thousands of real estate mortgages, which they bundled for resale into an interest earning asset like a bond. They called them Collateralized Debt Obligations (CDO), or Collateralized Mortgage Obligations (CMO) and more recently, Mortgage Backed Securities (MBS). In that way mortgages could be resold to smaller investors who would not normally buy individual mortgages.

What is important to notice though is that repackaging and reselling mortgages does not create new assets. Reselling mortgages means more transactions that allow money managers to charge fees and potentially make money with price fluctuations, but nothing new or usable results from the repeated resale of mortgages.

As the 1980’s passed through the 1990’s and into the new millennium the traditional means of finance like stocks and bonds were still available, but they gave way to Mortgage Backed Securities and new and exotic investment derivatives: principal only strips, interest only strips, credit default swaps and on and on.

Reselling mortgages as Mortgage Backed Securities got so lucrative that money managers started running out of mortgages to bundle and resell. To keep it going it was necessary to start lending to unqualified homebuyers, a practice that many will remember as sub prime lending and sub prime loans.

We have to think financial intermediaries with qualified homebuyers, or qualified business and corporate borrowers, would lend to them before lending to unqualified borrowers in the sub prime lending market. Lending billions to unqualified borrowers suggests there was a large surplus of loanable funds.

It is not surprising that a bubble of surplus loanable funds and the fantastic growth in Mortgage Backed Securities took place after tax cuts that further reduced tax rates at the highest incomes, but especially for reductions in taxes on capital gains and the new tax reductions on corporate dividends. These reductions helped increase disposable incomes for the richest Americans, as the IRS data so clearly shows.

Recall a recent need for loanable funds to rebuild New Orleans following hurricane Katrina. Instead America’s loanable funds went for transactions where nothing happened, save for gambling in speculative financial derivatives. And then we realize tax cuts for the rich helped generate an immense surplus of loanable funds that were wasted on financial speculation rather than building productive capacity because millions of wage earners could not buy what America can produce.

Where are you Henry Ford when we need you? In 1975 America taxed the rich at a 70 percent marginal tax rate, but not that many years before marginal tax rates were 90 percent. Now the rich tend to pay 15 percent on capital gains and dividends.

The rich failed themselves, but they also failed the country, which is why America needs to return to taxing the rich at 90 percent.