Berkshire Hathaway 2009 Annual Meeting Audience Question # 5

Why Berkshire continues to hold a large position in Moody’s despite its role in the financial crisis

Warren Buffett:

OK. Andrew, one of those 200 questions from this morning? Or what are…

Andrew Ross Sorkin:

This one’s not from this morning, but it relates to Moody’s. And we’ve probably received about 300 questions, at least, on this topic.

This question, which is representative of many, comes from Aaron Goldsmeizer. And the question is the following:
“Given the role of rating agencies in the current economic crisis… their conflict of interest, their reliance on, quote, ‘flawed history-based models,’ as you described in this year’s letter to shareholders, and the likelihood that a loss of credibility and/or regulatory reforms could force drastic changes in their business models or earning streams… why do you retain such a large holding in Moody’s?

“And more important, why didn’t you use your stake to try to do something to prevent conflicts of interest and reliance on these flawed history-based models?”

Warren Buffett:

Yeah, I don’t think the conflict of interest question was the… was the biggest…by anywhere close to the major cause of the shortcomings of the rating agencies in foreseeing what would happen with CDOs and CNBSs and all sorts of instruments like that.

Basically, five years ago, virtually everybody in the country had this model in their mind, formal or otherwise, that house prices could not fall significantly.

They were wrong. Congress was wrong. Bankers were wrong. People that bought the instruments were wrong. Lenders… the borrowers were wrong.

But people thought that if they were going to buy a house next year, they better buy it this year because it was going to be selling for more money the following year.

And people who lent them money said it doesn’t make any difference if they’re lying on their application or they don’t have the income because houses go up, and if we have to foreclose we won’t lose that much money. And besides, they can probably refinance next year and pay.

So there was an almost total belief… and there was always a few people that disagreed… but there was almost a total belief throughout the country that house prices would certainly not fall significantly, and that they would probably keep rising.

And the people at the rating agencies, one way or another, built that into their system.

And I don’t… I really don’t I think it was primarily the payment system that created the problem. I think they just didn’t understand the various possibilities of what could happen in a market— or in a bubble, really… where people leveraged up enormously on the biggest asset that most Americans possess, their house.

And so you had a $20 trillion asset class in a $50 trillion of total assets of American families that got leveraged up very high. And then once it started melting down, it had self-reinforcing aspects on the downside.

So I say that they made a major mistake in terms of analyzing the instruments. But they made a mistake that a great, great, great many people made.

And that probably if they had taken a different view of residential mortgages four or five years ago, they would’ve been answering to Congressional committees that would be saying, “How can you be so un-American as to deny all these people the right to buy houses simply because you won’t rate these securities higher?”

So I… they made a huge mistake. But the American people made a huge mistake. Congress made a huge mistake.

Congress presided over the two largest mortgage companies. And they were their creatures. And they were supervised by them.

And, you know, they’re both in conservatorship now.

So I don’t think they were unique in their inability to spot what was coming.

In terms of us influencing their behavior, I don’t think I’ve ever made a call to Moody’s.

But it’s also true that I haven’t made it to, or made… maybe made one or two… to other companies in which we’re involved.
I mean, we don’t tell, you know, the Burlington Northern what safety procedures to put in.

We don’t tell American Express who to cut off on credit cards and, you know, what they’re… who they should lend to and who they shouldn’t.

We are… when we own stock, we are not there to try and change people.

Our luck in changing them is very low, anyway. In fact, Charlie and I have been on boards of directors where we’re the largest shareholders. And we’ve had very little luck in changing behavior.

So, we think that if you buy stock in a company, you know, you better not count on the fact that you’re going to change their course of action.

And in terms of selling the stock, the odds are that the rating agency business is probably still a good business. It is subject to attack. And who knows where that leads? And who knows what Congress does about it?

But it’s a business with very few people in it. It’s a business that affects a large segment of the economy. I mean, the capital markets are huge. I think there will probably be rating agencies in the future. And I think that it’s a business that doesn’t require capital. So it has the fundamentals of a pretty good business.

It won’t be doing the volume in the next… probably for a long time in certain areas of the capital markets. But capital markets are going to grow over time.

We have said in this meeting in the past, many times, that Charlie and I don’t pay any attention to ratings. I mean, we don’t believe in outsourcing investment decisions.

So we… if we buy a bond, the rating is immaterial to us, except to the extent if we think it’s rated more poorly than it should, it may help us buy it at an attractive price.

But we do not think that the people at Moody’s, or Standard and Poor’s, or Fitch, or anyplace else, should be telling us the credit rating of a company. We figure that out for ourselves. And sometimes we disagree with the market in a major way. And we’ve made some money that way.

Charlie?

Charlie Munger:

Yeah, I think the rating agencies, being good at doing mathematical calculations, eagerly sought stupid assumptions that enabled them to do clever mathematics. It’s an example of being too smart for your own good.

There’s an old saying, “To a man with hammer, every problem looks pretty much like a nail.” And that’s… what happened in the rating agencies.

Warren Buffett:

Yeah, the interesting things about all those triple-As, is the people that created them ended up owning a lot of them. So they believed their own baloney, themselves. Every… the belief was enormous.

So you had these people stirring up the Kool-Aid and then they drank it themselves. And they… you know, they paid a big penalty for it. But I don’t think it was… I think it was stupidity and the fact that everybody else was doing it.

I send out a letter to our managers, only every couple of years. But the one reason you can’t give at Berkshire, as far as I’m concerned, for any action, is that everybody else is doing it.

You know, and just… if that’s the best you can come with, you know, something’s wrong. But that happens in security markets all the time.

And of course, it’s… when Charlie and I were at Salomon or someplace like that, it’s very difficult to tell a huge organization that you shouldn’t be doing something that people, well- regarded competitors, are doing. And particularly when there’s a lot of money in it.

And so it’s very hard to stop these things once you get sort of a industry acceptance of behavior. And you know, we were very unsuccessful, Charlie and I, at Salomon at saying, “Well, we just don’t want to do this sort of thing.”

We couldn’t even get them… initially, when we got in there at first, they were doing business with Marc Rich. And we said, “Let’s stop doing business with Marc Rich.”

You know, that’s like saying in the ’30s, “Let’s stop doing business with Al Capone,” or something. And they said, “But it’s good business. If he doesn’t do it with us, he’ll do it with somebody else.” And they felt that way. And I think we won that one. But it wasn’t easy.

You remember that, Charlie?

Charlie Munger:

I certainly do.

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