Saturday, March 14, 2009

What Would Warren Buffett Make of Anglo Irish Bank?

Warren E. Buffett is a greatly admired icon of the American business world. He was born in August 1930 in Omaha, Nebraska. He is ranked 2nd on The 2009 Billionaire List published by Forbes with a net worth of $37 billion, having been the richest billionaire in 2008, when his wealth amounted to $62 billion. He founded Berkshire Hathaway Inc in 1964. He has not increased his annual salary at Berkshire Hathaway beyond $100,000 (€78,000) in 28 years. Apart from salary, his overall compensation amounts to $491,000 (€384,000) but he will not be paid a bonus this year. He has also lived in his present home for over 50 years. He is still the Chairman of the Board and around 31,000 shareholders are expected to attend the company’s annual general meeting on Saturday, 2nd May in Omaha, an event that extends over a weekend and offers those attending the opportunity of an extensive discounted shopping spree at a wide range of Berkshire Hathaway consumer businesses!

Berkshire Hathaway investment interests are far reaching. They include the utility sector, insurance, manufacturing and retailing, finance and financial products and a wide range of investments in companies such as Coca Cola, American Express Company, Johnson and Johnson, Proctor & Gamble, sanofi-aventis, Swiss Re, Wal-Mart, The Washington Post and Tesco.

Buffet’s has very focused priorities:

  • He ensures that they maintain substantial liquid resources, commits to modest short-term obligations and has diverse sources of earnings and cash

  • He strives to ensure that each business has a robust basis (‘moats’) of competitive advantage

  • He develops operating managers who deliver exceptional results

Despite his accomplishments, not everything he was invested in has been rewarding. The past year has seen his wealth drop by 40% as a consequence of the fall in value of the companies he has invested in. Most of the Berkshire businesses were adversely affected by the economic developments last year but between 1965 and 2008 they achieved a compound annual increase of 20.3%, or an overall gain of 362,319% since 1964.

He invested $244 million on shares in two Irish banks in 2008 as they appeared cheap to him. But by the end of 2008 he had incurred an 89% loss on these, a development he describes as an ‘unforced error’ on his part.

Anglo Irish Bank was nationalised by the Irish Government on 21 January last on account of its systemic importance to the Irish financial system. Its former chairman and founder, Mr. Sean FitzPatrick, resigned on 18 December 2008 when it was disclosed that loans amounting to €87 million were not reflected in the accounts of Anglo Irish Bank and were hidden from stakeholder scrutiny at Irish Nationwide Building Society. While FitzPatrick maintains that this was a legal, if not transparent series of transactions, they would be unlike to pass muster with Buffett. Furthermore, the €1 million bonus and the 12% salary increase for 2008 paid to Michael Fingleton, the chief executive of Irish Nationwide Building Society is likely to be as much of an affront to Buffett as it is to Irish citizens.

The latest balance sheet of Anglo Irish Banks (at 30 Sep 2008), reflects €2,233,000,000 (€2.23 billion) invested in derivative financial instruments. Derivatives are financial contracts whose value is determined by an underlying value such as that of an asset, a commodity, a mortgage or even the movement of an index, such as an interest rate or the FX rate attaching to a particular currency. They are supposed to mitigate the risk of a change in the value of the underlying assets and that activity is hedging. The notional value of a derivative, based on the nominal value of the various assets underlying it, is not recorded on the balance sheet of the business owning it - but the market value is.

Buffett is scathing about structured derivative and describes them as ‘dangerous’ because they have dramatically increased the leverage and, therefore, the risks inherent in the financial system. It is almost impossible for investors to understand and analyze large businesses with substantial amounts of derivatives. He is likely to have similarly sceptical about securitized assets and leveraged funds.

An ordinary share can be bought or sold within days with one party obtaining cash and the other the corresponding security. There is no enduring counterparty risk which means that problems cannot fester. Rapid settlement is the vital to the integrity of the stock market.

But structured derivative contracts often go unsettled for years, or even decades and counterparties can build huge claims against each other. Paper assets and liabilities are hard to completely accurately assess; yet, in the case of Anglo Irish Banks, they are an important element of it financial profile.

A complex web of mutual dependence has developed amongst financial institutions with receivables and payables becoming concentrated among a small number of dealers who maybe excessively leveraged in other ways too. Buffett says that such participants “seeking to dodge trouble face the same problem as someone seeking to avoid venereal disease. It is not whom you sleep with, but also who they sleep with” that is the issue. The current financial crisis has demonstrated that only companies that can ‘infect’ a neighbourhood are attracting US government support and intervention.

Buffet believes that the chief executives of many large businesses were incapable of managing them because of the complexity of the derivatives those businesses are involved with. He doesn’t believe that any mechanism can provide sufficient transparency to describe or regulate derivatives or for auditors to audit them. He cites the collapse of Fannie Mae, Freddie Mac and Bear Sterns to support his opinion.

Buffett might also be curious to know if there is a connection between the Anglo Golden 10 that were provided with loans by Anglo Irish Bank to buy its shares outside normal market structures last year and those borrowers who owe the Bank more than €500 million. He might ask if this is the case were any covenants and obligations attaching to these loans broken at any time. If so what impact could this have had in persuading them to become involved in this Anglo loans for shares episode?

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