Jan 312009

0901-023-t-buffetIf there is one living human being who is as well revered and respected as Lord Jesus, it is Warren Buffet. A journalist will be taking biggest risk in his career if he ever dared to write anything against him.  “Just shut up and go for another theme, any theme, except him” his editor would say. Such is the sway of one of the most legendary investor and humble richest person on this planet.

I am taking a chance today, writing against his latest investment in Goldman Sachs ($ 5 billions) and General Electric ($3 billions).  This is yet third time in his career that Mr. Buffet has gone against his own self imposed discipline – not to invest in any company he does not understand.

He made his first error when he invested in troubled Solomon Brothers in early 90s.  He finally came out with little profit after spending fortune and management time. He is repeating mistake by investing in Goldman Sachs this time.

He erred again in acquiring General Re. Here again, he lost fortune and still owns the troubled baby.

The third and most disastrous mistake he made was this year – by investing into Goldman Sachs and General Electric. It is not the names in which he invested – they were no doubt the blue chips – it is the manner in which he invested into them seriously jeopardizing the interests of Berkshire Hathway shareholders.

He was overawed by the power, pursuit and personality of Henry Paulson, the Treasury Secretary during Bush Administration and ex- Goldman Sachs CEO/Chairman.

He simply allowed Paulson to prevail over his trusted vision and wisdom. Paulson simply forced him to accept the structure of his investment that was detrimental to him and Berkshire shareholders.  It is discussed later.

Buffet did not understand the monster of derivatives that was the downfall of Solomon Brothers. He still went for the golden knife in the name of Goldman Sachs. It is the nature of knife to hurt someone regardless of its material – steel of gold.

A knife is a knife – it ultimately cuts and kills. In a world of massive derivative collapse, he went for the pioneer of those derivatives – Goldman Sachs and another derivative colossus – financial arm of General Electric, a venerable name which is often gloated over and grossly overestimated.

As a biggest investor in the world, he knows practically all leading Investment Bankers, banks and brokers.  A first mistake every investor makes is to accept the advice of his broker or investment banker. Most investors do not buy the stocks: they buy the words of the advising broker.  If you want to buy say stock A (say IFCI in India) for sheer value, but your broker advises you buy stock B (say, ICICI in India), you will buy stock B. In short, you did not buy Stock B but the word of your broker.  If you buy some unknown stock at the instance of broker, you are buying broker’s confidence. That is, you bought broker’s word, not the stock.

It is the brokers who make the markets. They induce the enthusiasm in certain counter by active market making and increasing volume. The invitations are then sent out in the form of Broker’s research, overweighting or underweighting, future projections and showing you the moon at times. Why the markets are in bad shape today? Because most of the leading brokers or investment banks have gone bankrupt or are nearly bankrupt- Bear Stearns, Bank of America, Citigroup, JPMC, Lehman, Merrill, Goldman, Morgan Stanley, UBS,  RBS, Barclays etc. The list is unending.  They have no capital to make the markets or engage into pre-emptive proprietary trading.

The rules are simple – If there are no brokers, there is no market.

God usually gives two chances. A person suffers two heart attacks and survives. The third is a fatal one. We as human also give two chances to wrong doer. If he errs third time, we admonish, punish, severe the relationship or dump the errand boy. Warren Buffet made the third error in investing into GS and GE.

Let us see how he was duped by Henry Paulson and how he could have avoided the future mishaps in early stages of investment in same counters by taking proper precautions he was capable of. He is investment genius – he knows that but he was not aware of.  If he ever reads this article, he would realize what he missed and erred.

Buying Perpetual Preferred shares with convertible warrants – an ignominious route

When an investor becomes very rich, he develops the tendency of looking for higher yield.  His large cash holding does not fetch him enough interest in practically “Zero” interest environments. Often, I hear from the large investors – we are not getting good yield on our Bank deposits, Certificate of Deposits or Corporate bonds.  Where do we place our money now? Their patience is wearing thin, because low interest regime simply continued for far too long, 16 years in Japan and 8 years in USA.  This is why insurance giant like AIG risked out the free premium money into monetary misadventure and lost hundreds of billions of dollars for one simple reason – to earn better yield. These guys for the sake of 1 to 2% extra yield, forked out 100 in risky derivative and leveraged investments.

An Investor like Warren Buffet used to have great patience in his younger days. He would wait for extra ordinary opportunity, no matter how long he had to wait. It was more like a hunter that waits in the bushes to trap the tiger.  It was more like Chairman Mao of China’s philosophy or policy of winning a war – “Withdraw your self from everywhere as much deeper as you can, and let the enemy come in. When the enemy is deeply entrenched into your territory, then only pounce on him.”

In investment parlance, Chairman Mao would have said, “Withdraw your investments from everywhere, let the stocks or markets recede as deep as they can into your territory (buying range), and then only grab them on your terms.

However, advancing age is taking toll on him. He is now 78. He did not have luxury to wait for too long. His patience was wearing thin. And that forced him into errors.  By his own analogy, he did not wait long enough at the beach to let the tide recede to see who was swimming naked. Instead he reached out few steps into the sea to grab the swimmers who would have otherwise drowned to death.

In short, he did not wait for massive return. He was enticed by 10% yield on Preference shares. Instead of being a hunter, he became hunted.  He lent $ 8 billions just to earn 10% yield when the dictated FED rates were only 0.5%.  He never asked himself why such blue chip companies like Goldman Sachs or General Electric should pay 10% when the borrowings from FED could be had at less than 1%. In fact, he became a “Moneylender” from being an investor for rest of his life.

This was the biggest casualty of credit crisis.  Let us see how he invested insecurely and he could have invested with full security of his massive investment., nearly 25% of his Net Worth.

Warren Buffet’s Gamble in Investment

Goldman Sachs and General Electric

Details /Type

His Unsecured  Investment

Solution: Secured Investment

Goldman Sachs

General Elec

Goldman Sachs

General Elec

01 Date of Issue/Deal
02 Amount Invested $ 5 Billions $ 3 Billions $ 5 Billions $ 3 Billions
03 Route adopted Preference shares Preference Shares Convertible Bond Convertible Bond
04 Maturity of Instrument Perpetual Perpetual Limited period Limited Period
05 Considered as Unsecured Unsecured Fully Secured Fully Secured
06 Liquidity of Instrument Less than 20% Less than 20% 100% 100%
07 Possible Premium  or discount in Secondary Market -10% to -50% -10% to -50% + 30% to 300% +30% to 300%
08 Preference in liquidation Last Last First First
09 Coupon 10% 10% 10% 10%
10 Other Attached Instrument Convertible Warrant Convertible Warrant Bonds  already Convertible Bonds  already Convertible
12 Conversion Price $115 – Fixed $22.25 – Fixed $115  Variable or 20% below MP at any time $22.25 – Variable or 20% below MP at any time
13 Conversion Period Not known

First 5 years?

First 5 years During life of  the Bond During life of  the Bond
14 Buy Back option for Issuer (Callable) Yes, at any time @ 10% premium Yes, after 3 years @10% premium None None
15 Overall Security Least Least Most Most
16 Overall Return 10%  Interest

10% Premium

? Capital Appreciation

17 Overall Attractiveness Least Least Best Best

It will be observed that Warren Buffet has for some strange reason adopted the route of “Perpetual Preferred Stock” against conventional Convertible Bond approach. Following are the essential difference and risk involved:

“Perpetual Preferred Shares” PPS and “Convertible Bonds” CB– the major difference

It is simple. The PPS is part of the capital whereas CB is a debt. Under the law, debt has precedence over capital of any form – PPS (Perpetual Preferred Shares) or ES (Equity Shares). In the event of liquidation of the issuer, the debt holder has priority over PPS and ES.

I remember of United Airlines, which when liquidated, gave nothing to shareholders. Entire equity was cancelled – preferred and ordinary equity.  After writing off the existing capital, the company was handed over to debt holders who got the controlling interest in the form of new equity.  Before liquidation, the stock of USAL traded in few cents and after liquidation, when all existing shareholders were wiped out, the new stock issued to debt holders rose close to $50 per share.

When Mr. Buffet could have got the same deficit, had he asked to contribute by way of CB rather than PPS, why did he chose to adopt more risky form of investment via PPS?

Low Marketability of PPS versus CB

Perpetual Preferred Shares always have very low form of liquidity. Because they are “perpetual” that is , the company is never supposed to redeem then and pay off the holders, they trade at a very deep discount. When I was a bond trader, I have handled trades of the perpetual of banks like HSBC and Standard Chartered Bank at discount of 25% in good market to over 52% in bad market.

In essence, the PPS will lose the value instantly by 25% to 50% the moment it trades in secondary market.

An investor should see, before he invests, how he would be able to cash in his investments in case of need. In this kind of bad market, there will be no buyers for GS or GE PPS.  If some one makes a market, it may trade at 20% to 50% discount, even if the interest coupon is 10%. When a company’s existence is at stake, which investor is going to trust  that company whether it would pay interest @ 10% in time.

CB on the other hand, trade very actively in the market. They have limited life like 10 or 15 years. The holder is having assurance that the company will have to pay off the debt at the end of expiry of its tenure. This is why the CB trade at 30% premium the moment they are issued as against discount in case of PPS.

Further, in case of SB, there is one instrument, whereas in case of PPS with Warrants attached, there are two papers – PPS itself and Warrants. This again restricts its marketability because both papers could trade separately.

Negative covenant for payment of dividend for companies under debt default

PPS holders are not entitled to receive the dividend (10% in present case) if there is debt default. Most of the debt instruments have “negative covenant” binding company not to pay dividend on equity or preferred shares if there is a “default on debt”. Thus, in case of default on GS and GE debt, who are heavily leveraged, Mr. Buffet would not get even 1% dividend in case there is some default.

Had he opted for CB, he would have been entitled to interest payment @ 10% periodically. If there is default, CB will get priority in payment of interest over its dividend.

In short

Warren Buffet appear to have made very serious mistake in structuring his investment of $ 8 billions in the form of PPS. He stands to lose immediately $ 4 billion minimum at market value. He was obviously influenced by the charisma of Henry Paulson who structured the deal for him and also for US government. Mr. Paulson was an expert Investment Banker at Goldman Sachs, He knows pretty well the difference between PPS and CB and their respective priorities. Even then, he duped US Government and Warren Buffet into unacceptable deal in the form of PPS which seriously endangers the securities running into hundreds of billions of dollars for US government and over $ 8 billions for Mr. Warren Buffet.

As I have said before, the people do not buy the stock or bonds – they just buy the broker’s words, promises or confidence.

By listening to Paulson, both US Government and Warren Buffet (his investment vehicle – Berkshire Hathway) have become victim to hard selling tactics. They exposed themselves to enormous risks.  US tax payers will have to pay through their nose almost 2 trillions shelled out by the Treasury and FED, although official disbursement under TARP was only $ 350 billions out of $ 700 billions. Paulson has proved to be a “parasite” while he was the Treasury Secretary. Future generation of United States will never pardon him for his unnoticed crime.

It looks like that Mr. Buffet is on downward hill.  A book called ” Warren Buffet Speaks”  (290p ) may be of interest to the readers of this blog. It is free and downloadable as PDF or viewed on screen on clicking that link   Warren Buffet Speaks or full link http://www.scribd.com/doc/7674709/Warren-Buffet-Speaks

After reading, you may as well ask why not Mr. Warren Buffet himself read it again. There is no need to change the time tested methods that worked for him all along.

Anil Selarka (Kalidas)
Hong Kong

January 31, 2009 (Article Ref: 0901-023)

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