[0:40]
Othernow come back in the session. We are going to begin the second session of today's hearing on the credibility of credit ratings, the investment decisions made based on those ratings and the financial crisis. This second session is credit ratings in the financial crisis. We are joined today at the witness table by Mr. Warren Buffett, the chairman and CEO of Berkshire Hathaway, and Mr. Raymond McDaniel, the chairman and CEO of Moody's Corporation. Gentlemen, I'd like to start, thank you for being here. I'd like to start by doing what is customary for all witnesses in all proceedings. I'd like to ask you both to stand and be sworn. Please raise your right hand. Do you solemnly swear or affirm under the penalty of perjury that the testimony you're about to provide the commission will be the truth, the whole truth, and nothing but the truth to the best of your knowledge? Thank you very much. We will begin by offering both of you the opportunity to make an opening state. statement of no more than five minutes. I don't know if I, I know that Mr. McDaniel has prepared a statement and I don't know Mr. Buffett if you want to avail yourself of that opportunity, but I have no statement. Okay, well that'll cut five minutes off the agenda. And Mr. McDaniel, I think what we'll do is take your opening statement and they'll go right to Commission questions. Thank you. Good morning, Mr. Chairman, Mr. Vice Chairman and members of the Commission. My name is Ray McDaniel. I'm the Chairman and the Chairman and CEO. of Moody's Corporation, the parent of Credit Rating Agency Moody's Investor Service. Moody's appreciates the important work this Commission is undertaking. And on behalf of my colleagues, I welcome the opportunity to contribute our views regarding the role of credit rating agencies. Over the past several years, we've witnessed events whose magnitude many of us would have thought highly unlikely. The turmoil in the U.S. housing market that began in the subprime residential mortgage sector led to a global liquidity crisis and a loss in confidence in the U.S. and global financial system. system. The impact has created a great hardship for many Americans. American families have lost jobs, homes, and college and retirement savings as a result of this financial crisis. Moody's is well aware that the crisis of confidence in the market has also impacted the confidence in the credit ratings industry. At Moody's, our reputation is our single most important asset. For 100 years, Moody's employees have brought their insight and integrity to rating trillions of dollars of debt and hundreds of thousands of obligations across a broad
[3:13]
Otherof sectors, asset types, and regions. The record for providing predictive credit opinions has earned Moody's a strong reputation among capital market participants worldwide. However, Moody's is certainly not satisfied with the performance of our credit ratings for the U.S. Residential Mortgage Back Securities and related collateralized debt obligations over the past several years. Indeed, it has been deeply disappointing. Starting in 2003, Moody's did observe a trend of loosening mortgage underwriting standards and escalating housing prices. We repeatedly highlighted those trends in our research, and we incorporated them into our analysis of the securities. By 2006, we were requiring an unprecedented level of credit protection. However, neither we nor most other market participants, observers, or regulators, anticipated the severity or speed of deterioration that occurred in the U.S. housing market or the rapidity of credit tightening that followed and exacerbated the situation. And even our enhanced credit protection requirements were insufficient to ensure rating stability. Today, with the benefit of hindsight, many observers have suggested that the events that ultimately came to pass were inevitable and easily predictable. As they were occurring, however, various outcomes were considered possible. Market experts in both the public and private sector had differing views about the ultimate performance of the U.S. housing sector and its potential effect on the rest of the economy. These questions persist today. The economic downturn exposed serious vulnerabilities across the infrastructure of the global financial system. For Moody's part, there's been an intense level of self-evaluation over the past few years. Members of my management team and I have solicited ideas and perspectives from both inside and outside the company. We've sought to better understand what caused the poor performance of our ratings in this sector, and we've sought to improve the assessment of credit risk in a fast-changing and unpredictable market environment. We've undertaken numerous initiatives to improve the credibility of our ratings and strengthen their quality, transparency, and independence. These actions are extensive and have occurred in six principal areas. six principal areas. We have strengthened the analytical integrity of our ratings, enhanced consistency across rating groups, improve the transparency of ratings and the rating process,
[5:21]
Otherincreased resources in key areas, bolstered measures to avoid conflicts of interest, and we continue to pursue industry and market-wide initiatives. In each area, we've made good progress. Still, I believe that more can and should be done. We wholeheartedly support legislative and regulatory reform efforts that will reinforce high-quality ratings and enhance accountability without intruding into the objectivity and independence of rating opinion content. At Moody's, we are firmly committed to meeting the highest standards of integrity in our rating practices, quality in our rating methodologies and analysis, and transparency in our rating actions and rating performance metrics. Thank you. I'm happy to respond to any questions. Thank you very much.
QuestionerAll right, we'll begin with the question. So, and I will as custom start and then move to the Vice Chair and then the members who led this research and investigation effort into credit rating agencies. Let me start by saying the two issues I'd like to probe with you gentlemen today are really the following. First of all, business and management practices, corporate responsibility, management accountability, for starters. Second issue I'd really like to look at and talk with you about is the model for credit rating agencies in the financial market. So Mr. McDaniel, let me start with you today. And let me ask you very directly. And by the way, the reason I want to say that these issues of corporate governance, leadership accountability are important, is in trying to assess how we had this run-up to the financial crisis. We have found over the course of months that there's very little, there's a lot of fingers pointing away, very little self-examination. So let me start with you. Under your leadership, there were in the end, for whatever reasons very significant. failures at Moody's. The product that your company offered, which are ratings, for the benefit of investors, proved to be highly defective, and not just by small measure, but by a large amount. 83% of your AAA rated securities in the RMBS area in 2006 were downgraded. In 2007, 89% of those which were investment grade rated were downgraded to junk. And massive downgrades, I ought to note, started in July 2007 when housing prices had declined just 4% from the peak. Some have said that the very enterprise was fraudulent, if not in a legal sense, but in a practical sense, because the products did not closely approximate what they represented to be.
[8:00]
QuestionerIf we had flipped a coin with respect to your 2007 ratings, it would have been five times more accurate in terms of the result. Your shareholders have lost 73% of the value in the stock from the peak to today. The ratings enable the issuance of trillions of dollars of mortgage securities, which we now know were rife with significant problems, from fraud to misrepresentation that may have well fueled the housing bubbles. Investors who relied on the ratings suffered enormous losses. And your company's reputation is something I know that Mr. Buffett has held important. Reputation within business is certainly under... significant criticism. My question for you is really, who should be held accountable? We have a system of capitalism in this country where we have regulatory mechanisms. We have owners, boards, and management. Who should be accountable if not you?
OtherThe performance of the housing sector and as a result, the ratings that are associated with housing assets clearly have exhibited very poor performance in recent years. There was decades of strong performance leading up to the current crisis. We believed that our ratings were our best opinion at the time that we assigned them as we obtained new information and were able to update our judgments based on the new information and the trends we were seeing in the housing market. we made what I think are appropriate changes to our ratings. So I am deeply disappointed, as I said in my opening remarks, with the performance of ratings associated with the housing sector. And that is injurious to the reputation of the firm and to the long-term value of the firm. And so the regret is genuine and deep with respect. to our ratings in the housing sector.
QuestionerBut let me probe this a little further. I mean, just as a kind of, look, and I've been certainly wrong as much as I'm right. I know it's hard to predict peaks and valleys. But let me just say, there's almost a common sense test here. Your firm rated 42,000 tranches of RMBS, AAA, from about 2000, 2007, 2007, in a context in a context where there's four corporations in the country. be a few more that are rated AAA. In the context, you were rating about 90% of these securities as AAA when, in terms of the corporate debt world, where you actually have more transparency. You can get in, look at all the public filings, understand the corporate debt, only about 1.4% of that was rated AAA. You led an enterprise for which you were compensated
[10:55]
Otherpretty handsomely, $39 million over this period. I guess what I'm getting to is if American capitalism is about risk and reward, rewarding success, rewarding failure, should there have a management change at Moody's. Don't we need to have a culture in which success and failure are essentially accounted for in our capital system?
OtherAs I remarked a moment ago, we certainly believed that our ratings were appropriate when they were assigned. And I recognize that those ratings have not performed well in the housing related sector. And as a result, we did make management changes. But not at the top. If you're asking with no board or CEO changes or if you're asking with respect to me, which I can see you are, it's a fair question. And if we reach a point we're either our shareholders or our board of directors or I don't believe I am best position to lead the firm in the future, then I will not be in my job.
QuestionerOkay. Mr. Buffett, any observations on the responses by Mr. McDaniel?
WarrenWell, I've probably been more draconian than you have in terms of my view about the CEO's responsibility and... I just haven't been as widely quoted. Well, in terms of financial institutions that have failed and required assistance by the federal government, I think that... when society has to step in to save institutions for societal reasons that the CEO should basically go away broke. And I've said, I think his spouse should go away broke. I mean, I think there ought to be a real downside. And I think incentives are an important aspect and behavior. In the end, you know, I'm not, I don't know who, except for maybe John Paulson or Michael Burry would have been running Moody's and coming up with different kinds of ratings. There was the greatest bubble I've ever seen in my life, and I've read about bubbles all the way back to the tulip bubble. The entire American public eventually was caught up in a belief that housing prices could not fall dramatically. And Freddie Mac believed it, Fannie Mae believed it, Congress believed it, the media believed it. I believed it. If I'd seen what was coming, would I've held my moody stuff in the 60s or something of the sort. But very, very few people could appreciate the bubble. And that's the nature of bubbles. They become mass delusions of sorts. So I am much more inclined to come down hard on the CEOs of institutions that caused the United States government to come in
[13:55]
Questionerand necessarily bolster them than I am on somebody that made a mistake that 300 million other Americans made. Well, but let me probe that a little because, you know, I just, I just want to say for the record, I do think around the country, there were people who thought the bubble was unsustainable. I think there was a secret here. There were a number of experts, whether it was Robert Schiller or Mr. Rabin either, or Mr. Baker, Dean Baker. There are a number of people who saw this bubble. We did have this unprecedented rise, 89% in home price appreciation in seven years, something we had never seen historically. But kind of, you know, moving beyond that for a minute, the rating agencies did play a fundamental role in accelerating essentially a securitization. Therefore, some would argue, the origination of products that tended out to be, tended to be highly deficient. We're talking about low teaser rates, negative amortization. There was a warning in 2004 from the FBI that mortgage fraud become so epidemic that if unchecked, it would result in a crisis as big as the S&L crisis. I mean, there were many red and yellow flashing lights along the way. there is a country song by Don McLean where he says when the gates are all down and the signals are flashing and the whistles are screaming in vain and you stay on the tracks avoiding the facts you can't blame you can't blame the wreck on the train wasn't the role of the rating agencies though to be referees in a game that got out of control you told our staff that well gee if they had not done the ratings they would have been howled out by conference Congress, but don't we expect referees to make the call, even if they're going to get booed?
WarrenYeah, and they made the wrong call. I mean, they basically believed, as most of the American public did, and you couldn't have had this size bubble without overwhelming. And the Cassandras were there, but who was going to listen to John Paulson in 2005 or 2006 from Michael Burry? I mean, it didn't mean anything. And, you know, and I look at me. I mean, I was wrong on it, too. I recognized that something pretty dramatic was going on. on-in-housing, but I actually called it in the annual meeting when I got a question on a bubbleette. Well, that was a terrible term to use. It was a four-star bubble, and the rating agencies missed it. And, you know, as I say, you could look at the March 30th, 2007 report to Congress by O'Feyo, which had 200 people overseeing Freddie and Fannie, and they basically gave them a green light on asset quality.
[16:32]
QuestionerWell, I actually think I take a different view that if you look at O'Feyo's reports, which we've had access to. too, they raised a number of issues. But moving on from that, you had, you said the ratings business was a wonderful business. You've said that, you know, as a matter of fact, because it's a duopoly, little capital required, enormous pricing power. Turned out to be good for a short time, not necessarily I think the model that works best for the marketplace. But I want to return to this matter of corporate governance and accountability. You are the largest shareholder. and I realized by all accounts you were not a particular, in fact you described me as not particularly active would probably be too aggressive. You had very infrequent contact, I think only twice with Mr. McDaniel, and maybe a little with Mr. Rutherford when he, during the years, he would come to visit you. But I want to probe the responsibility of shareholders. This was a company where 50.5 percent, I think, of the shares are hold by five large owners. You had this tremendous spike in revenues coming from. from structured products. We've heard today from, and in the course of our interviews, a lot of concerns about the change in culture at Moody's, the pressure for profits, sacrificing ratings, quality. I guess I would ask you, what do you think are the appropriate roles of shareholders and boards of directors in monitoring companies? What responsibility to kind of look into the culture, problems that are rising and did the board and the shareholders do what they should have done in this respect?
WarrenYes. In 2006, I was not sitting there thinking that the housing bubble was going to get as large as it did, or as it was actually, and it was going to burst. And like I say, if I had, I probably would have sold my stock.
QuestionerYeah. So I'm going to keep at this a little. I mean, given the dramatic consequences that have happened here, and I do think there have been reputational damage. I think you once famously said it takes 20 years to build. a reputation, five minutes to ruin it. If you actually think about that, something like, you'll do things differently. I guess the question is, in the end here, the ratings were wrong. There are reputational issues. There's been a massive loss of shareholder value, and the whole business models come apart. I mean, should there be a new board? Should there be new management after this kind of change?
[19:02]
QuestionerI would say that in this particular case, I think they made a mistake that virtually everybody in the country made. And going back to that O'Feyr report, March 30th of 2007, it was reported the enterprise's overall asset quality is strong. That was March of 2007, and all they owned was mortgages. Well, I will just say, you know, arguing with you about what the markets were saying, but I mean, this was not a big secret. This is the economist. After the fall shows housing prices falling like a brick. There were a lot of warnings. Even Moody's.com, Mr. Zandi is a very capable man. So I guess, you're saying. You're saying the magnitude of the mistake doesn't in the end warrant change in management re-look at the culture of the corporations. Certainly. It's not necessary. And incidentally, I don't think the economist ran an article called before the fall. This was 2005. Yeah. All right. Let me move on and ask this. One last question, Mr. Buffin, then back to both of you very quickly. We interviewed a member of the Moody's board, Nancy Newcomb, who indicated the board was not particularly involved. and didn't discuss significant issues like the ratings process. There was a recent press account, I think, in the McClatchy newspapers about the disengaged nature of the board, but also said that two senior executives approached you with significant problems at the company. No. No? No. Okay, so not accurate. No. Okay, thank you. I want to talk to you both briefly about the model for credit rating agencies in the context of this marketplace. It seems to me there are, you know, a, you know, the worst of many worlds here. You have an issuer pay model by its nature that creates pressure to produce credit ratings to serve the interest of the issuer, not the beneficiary of those. In fact, Charlie Munger has said, I think, as you know, whose bread I eat, his song I sing. I've seen him say that a number of times. You have the duopoly with enormous pricing power. And in the end, you have also business that has a number of times. also business has had a whole set of legal protections, including First Amendment protections. It seems to me like a pretty toxic brew of corporate, not in responsibility here. Do you think radical surgery is necessary? For example, Mr. Buffett, do you think we had to outlaw the issue or pay model? Do you think we ought to adopt the Franken provisions in the Senate bill, which would say that rather than issuer selecting rating agency, they should be selected,
[21:39]
Questionerby the SEC? What kind of radical surgery, had it been performed early enough, might have helped in the sense that these rating agencies would not have enabled this flood of toxic mortgage securities?
WarrenWell, as Chairman of Berkshire, I hate issue or pay. I mean, we pay a lot of money and we have no negotiating power. As Treasurer of the State of California, I deeply resented the model myself. Yeah, well, it makes for a wonderful economic model for the business, but as a practical matter, I have no negotiating power. I need a Moody's rating and a standard employer rating. I need both of them. It's required in many cases by the rules under which our life insurance company operates or our property casualty company. So if they say to me, my bill is a billion dollars, and I say, gee, you know, I'd like it to be 900,000 or I'll go down the street. Essentially, there is no down the street. And that's the nature of it. Now, if you go to something other than user pay, it gets very tricky because who am I, you know, if If my daughter's going to buy a $10,000 municipal bond, is she going to pay for a rating for somebody? No, she'll hear the rating someplace, or be published in some book. But UL does it, United Labs now. That's a non-profit model, so you don't have the profit pressure. Consumer Reports does it. Is this a broken model? Well, if consumer reports would want to rate bonds and people would accept those ratings, I suppose it could happen. But it would require a pretty fair expenditure of money to rate thousands of money. municipalities and thousands of corporations. So I'm not arguing that this is the perfect model. I'm just saying it's very difficult to think of an alternative where the user pays. I'm not going to pay.
QuestionerWhat about selection of raiders by other than the issuers, for example, by a panel?
WarrenYeah, well, in effect, you've got selection now by directive. And in effect, I am told by the Nebraska Insurance Department, you know, which raiders I have to use in terms of establishing. So what about that is a change? Might that have obviated some problems? Should it be done and might it I don't know the answer to that. The wisdom of somebody picking out raiders, you know, is that going to be perfect? I don't know.
QuestionerWell, there are several alternative business models that rating agencies operate under. The largest rating agencies operate under the largest rating agencies operate under an issuer pays model. And I think it's important for us to acknowledge and recognize that any business model in which
[24:09]
Questionerthe fee payor has an interest in the outcome is a model that has potential conflicts of interest and that those conflicts must be managed transparently and properly. But can they really, you know, Fannie Mae and Freddie Mac, since you raised Ophail, I mean, here are institutions that had this push pull. They had the mission, but also the profit motive. The profit mode is pretty powerful, both on the issuer side and in terms of your business model. Can it really be over? I mean, it's nice to say that it's like transparency. Everyone loves transparency. And then they also say we can, we can, you know, we can handle our conflicts. Is it really resolvable? Because it doesn't appear to have been based on this latest period.
OtherWell, the poor performance of ratings from the 2006-2007 period in residential mortgage-backed securities and other related securities, housing-related securities, is not at all been replicated elsewhere in the business. So to the extent that there is a concern that we cannot have superior ratings quality, even in the midst of a severe economic downturn, I think is a misunderstanding. And as I said, because the parties that are willing to pay fees for ratings, whether it be issuers or investors or governments have an interest in the outcome of those ratings. I don't see how to avoid potential conflicts of interest. And we also, under the issuer pays model, have an important public good that is produced, which is the ratings are made available to the general public for free. There is no selective disclosure of the ratings. Large institutions do not have an advantage over smaller institutions or individuals in terms of the access to the ratings. I think that's an important public benefit.
QuestionerOkay, but I want to probe this because this goes to management. Look, this structure of products division was a cash cow. I mean, this is a classic case sometimes if it's growing like a weed, maybe it's a weed. I mean, you went from about a hundred and some million dollars in revenue in this section to 700 million. And there are questions about whether you staffed up enough to do it. It became 53% of your revenues. I mean, it became a huge part of your business to say, well, we did find out, we just missed here. I mean, the miss was huge. huge. I mean, 90% downgrade. I mean, even the dumbest kid in the class gets 10% on their exam. I mean, it seems to me that the resources were not applied to understanding these products.
[26:50]
QuestionerI mean, I happen to come from the real estate business. I asked your folks earlier today, did you actually have due diligence teams that went to the ground to places like Riverside or Bakersfield, where Mr. Thomas is from, or Sacramento, where I'm from, and take a look at the borrowers, the nature of the home markets. It doesn't seem to me you built in the capacity from a management standpoint to really do structure products well. I mean, this was a huge new industry that, yes, brought in revenue, but it doesn't seem to me from a pure management perspective. I think this is my point, Mr. Bob. It wasn't just a mistake that the resources to understand this were put in place. We've spent countless hours here trying to understand the modeling. And the truth is, if you look at the modeling, data was put in that was relatively, frankly, incomplete, inadequate. There was a lot of human judgments, but there wasn't a lot of ground-level due diligence. In fact, none other than visits to originators. So isn't that a significant management failure to not have built in the capacity? Might you have missed this less had you been truly on top of this in terms of understanding the products?
OtherI think that we certainly believed we were on top of this and we believed that the information that was being made available was adequate. There are other parties in the marketplace who had have other roles and responsibilities with respect to evaluation of properties and and review of mortgage applications. So we are analysts. We consume that information. We believe our role is to look at the information and look at the data and process that as part of our rating committee analytical process, not to replicate or duplicate roles that others in the market.
QuestionerWhich they didn't do.
OtherWhich they didn't do. It would appear that in some cases they have not.
QuestionerNo, they didn't do it. They didn't have fraud detection. Underwriting standards went to hell in a hand basket.
QuestionerMr. Buffett, any observations on whether this was just a pure modeling mistake or whether, in fact, it was also a lack of attention in terms of the depth of due diligence?
WarrenI mean, can I say something, you're a big advocate. Let me just kind of, you're a big advocate, do your own due diligence. Absolutely. So here you have an entity that's a surrogate due diligence. provider in a sense. And, you know, even whether people fully rely, having looked at real estate investments, you can ask the third party, but if you're going to outsource due diligence, you would hope your due diligence entity would be doing due diligence. Shouldn't rating agencies, shouldn't they have done actually ground level due diligence, sipping those blizzards at a dairy queen rather than just looking at the revenues?
[29:24]
WarrenThey really, looking back, they should have recognized, but like I say, I didn't recognize it, and most everybody I know didn't recognize it. They should have recognized it. They should have recognized this was a huge bubble. And as I understand it, they had something in the model, and I may be wrong on this, that there wouldn't be a correlation throughout the country of the same experience. And it's true that in the past you'd had housing boom someplace that had been sort of localized, but this was a nationwide bubble. Well, and so diversification among states didn't really make that much difference. It was worse to be in Nevada and Arizona and Florida. But it happened every place. And that was not the problem. In 93, we had actually a national 2% decline in house prices because of the big drops in places. And, you know, there is that old line. I mean, you know, one rotten apple can spoil the bunch. I mean, this was an instance where half the apples may have been rotten. I mean, the correlation assumptions, I think, were not very well defined or thought out. All right. I've asked you plenty for right now. Let's move on to the vice chairman. Thank you very much.
CharlieThank you, Mr. Chairman. Mr. Buffett, notwithstanding the subpoena, I want to thank you for coming. I want to thank you for the subpoena. I wanted you to have a frame copy for your wall. It's already up. I think it was good cover because then you can tell others that you don't want to go to if you got the power, use it. I admire that sort of structure. I also don't have anything for you to sign. But when I was younger, when Monday night football began, Don Meredith and Howard Kosell were the team and Don Meredith would launch in at least once a game with the ifs and buts were candy and nuts, we'd all have a Merry Christmas. And at this point, I'm not interested in going after the ifs and buts because there were plenty to go around. I am a very strong supporter and have tried to maintain the argument that behavior has consequences. You can do it when your ability to threaten someone with something either as an incentive or as a negative can influence that behavior. But I am very concerned about the amounts of money that were generated in a structure that provided those short-term opportunities. no long-term downside and apparently no moral angst over having done it. And there is to a degree, I think, an argument that this is basically, you know,
[32:17]
Questionersomebody's idea of unfettered capitalism to a very great extent. Um, you've made comments in that regard. How concerned are you that we're able to get this genie back in the bottle to the bottle to the point that if behavior has consequences, you want to claw back monies that they have. I don't see anybody being able to put that structure in place. How do you feel?
WarrenI think it could be put in place, but it requires a whole new level of thinking. But I think you're absolutely right. Incentives affect behavior, and when you run a huge financial institution whose stability or instability can affect the entire society, I think there ought to be a tremendous downside. It's fine if there's a tremendous upside, too. I don't have a problem with that. But I think that for somebody's, if somebody's personal equation as CEO, some large financial institution, is that they ruin the place, they walk away with $100 million instead of $500 million. And if they succeed, maybe they get a billion. I think that is a crazy structure. And I think that boards of directors should not sign on for such a structure. And I think that the boards themselves should bear heavy penalties when an institution has to go to the the federal government, and I think that that should not be insurable. So I wouldn't be as draconian as I have with the CEO, but I would want to focus the attention of somebody running a huge financial institution on the fact that their mistakes could cause big problems for the society.
QuestionerThank you. I thought I got out of the business. I did 32 years, and I didn't think I was going to be back on this side of the desk asking questions of witnesses again. again. But I said yes to this because of the way this commission has been structured. It's basically my belief that it's just pure public service. I thought it was wise of the Congress to structure us not to look for answers to those ifs and buts in terms of projecting forward what we ought to do, because frankly, Congress is trying to address those. I'll have a question on that in a moment. But our job is just basically to try to explain the financial crisis and do it as accurately as we're able with the resources that we have. So one of the reasons I was pleased to have, notwithstanding the subpoena, the coincidence of you being in New York and our desire to be in New York, to have you in front of us. So that I would hope that the answer that you would give me to your question isn't the one that very
[35:00]
Questionervirtually everyone else has given because it's not unlike the behavior in the consequences. The answer is somebody else. And given your reputation, but frankly, reputations are only as good as your balance sheet, you've got a really good reputation. I'll settle for that definition. In terms of understanding how things work, in your estimation, I don't want to drag us through this business this business of woulda, could, or shoulda, ifs, and buts. We have legislation moving through the House and the Senate that hasn't gone to conference yet, and it isn't locked up. And I have kind of preached to anyone who wants to hear that committees have such narrow jurisdiction that you're not going to be able to solve the fundamental problems, whatever they are, as we examine them, with a single bill that's principally gone through two committees that have roughly the same jurisdiction. You're just not going to hit it. So what I would like you to do, and I would ask both of you that if the Commission provides you questions in writing, would you be willing to answer them because we do not have the ability in the time we have to get to what we really need to do. Would, Mr. Buffett, would you be willing to do that?
WarrenSure, I'd do that. And incidentally, I did have a very good session with your staff that was recorded for two hours. And we have that and we read it. And I really think they did a good job of asking them both good questions and good follow-up questions, so I would hope some of the material might be in that record. And we're reviewing it to make sure it is.
OtherYes, we would do so also.
QuestionerWhat do you think the House and the Senate has gotten mostly right in the legislation that's moving through Congress and where, if there are obvious misses, I don't think we need to deal with subtleties now. It might be in some follow-up written questions. I haven't read the 1,500 page bills. No one has, including some of the co-sponsors. of the co-sponsors, so that's a denial that's okay. Okay, but I've got two thoughts, basically, then I think I would address if I were, one is this question of incentives. I mean, I think it is very important. I think it's, I think no one has any business running a huge financial institution unless they regard themselves with the chief risk officer. They are responsible for the ship. And if they aren't, they should, willing to take that on. Somebody else should be in that position.
[37:28]
WarrenSo I think there has to be huge downside for that. for the CEO and significant downside for the board if government help is required. The second thing I think is that part of any huge bubble is excessive leverage. And it's very hard to define leverage because you can have some institution that's 10 for one and their assets are all Treasury bills and doesn't make any difference and you can have somebody that's three for one and it can be all second mortgages and you've got lots of trouble. So it's not easy to define, but the size of the pop of the bubble was accentuated in an enormous way because of the leverage that existed in the system. And some of it was hidden, you know, off balance sheet type things. But I would, those would be two points I would try very hard to address intelligently. Thank you.
OtherMr. June, you want to ask a question?
QuestionerYeah, just one on the kind of incentives upside and downside. And I do want to just return, because you've talked about financial institutions, but the very structure, again, of credit rating agencies, it does seem in the end that there's lots of upside, you know, as the structure of product, business group, but very little downside. Legal protections. And by the way, I think there's a fine distinction between financial institutions that receive federal money, and I might add, a credit rating agency that's a full participant in the system that got us there. So wasn't this system tilted in terms of lots of upside and no downside? I think much of corporate America is tilted that way. But you would say that applies to credit rating agencies. I know you're an owner, but come on.
WarrenNo, I think I'll help me here. We've seen significant downside. I mean, there's no question that the mistakes that were made at Moody's and Standard & Poor's have affected both Moody's stock and McGraw-Hill stock in a big way.
QuestionerI have no right to ask you this, but just as the rating agencies produced whatever a AAA was, and then investment banks and others were able to take the leftovers, restructure them, and turn them into more triple A's rated by by an agency. You really need to speak out even more than you have about fundamentals. There aren't very many people who can command the respect, and I know you were really busy out there on a chair in front of a number of different channels. But you've got to do more of this. This may be your real legacy.
WarrenWell, I've spoken out of some things, but I've spoken out of some things.
[40:11]
WarrenBut I don't disagree with you that perhaps no one spoke out enough in the past years during the bubble. But certainly I could have done more. My partner, Charlie Munger, sometimes makes up for me, though. He speaks very loudly. But I agree with you, Mr. Thomas. Because once Congress acts, the ability, as you well know, to act again, to move into areas they weren't able to, initially political becomes virtually impossible. or you only try to clean up the area that you moved with first. This isn't nearly as comprehensive as it needs to be. It may even need to move to tort in other areas. So I am going to turn my time over to others who might want to quiz you from a very particular point of view. Mine's simple. Capitalism has changed in your lifetime. And my concern is that in those who are watching, it gets better, which means responsibility. moral obligation and behavior has consequences. Thank you. Thank you. All right. Thank you very much, Mr. Thomas. We are now going to move to Senator Graham. And yes, wheel the chart. Microphone.
QuestionerThank you very much, Mr. Buffett, Mr. McDaniel, for your insightful comments. Mr. McDaniel, you said that Moody's had incorporated the research search into its rating process. The chart that's about to be placed, I... Can we please place it where we placed it before, Karen, so we do not obscure commissioners. And if you have to move the chairs, move the chairs, stop the clock, even though we should charge the senator for this. Not in the Jericho sense, however, the real time keeps... Move on. This chart indicates the mountain of... The mountain of R.S. R.MBS securities that were rated by Moody's as the blue and the red or the CDOs, and then in yellow boxes are some important events. The first of the yellow boxes is in October of 2006, when, for instance, on the CDO line, it was something south of $10 billion issue. When Moody's research service issued a report of the first paragraph, the executive summary, saying the U.S. housing market downturn is in full swing. New and existing home sales and single-family housing construction are sliding. Inventories of unsold homes are surging to new record highs. House prices are falling in an increasingly number of areas. And the word crash is used to describe the situation in areas of the country which represented about half of the outstanding mortgages. How was that information incorporated into the subsequent rating processes of Moody's?
[43:44]
OtherThe Moody's analysts and Moody's rating committees have information from other parts of Moody's, as well as as information from other firms and governmental services available to include in their rating committee deliberations and their analysis. So, and they do use multiple sources of information, including source from Moody'seconomy.com. Yeah. Recognizing that this internal document as well as external information is available, The question is how in October of 2006 was this incorporated into the rating process?
OtherI don't know exactly how it was used in the rating committees. The concern is that immediately after that dire prediction was issued, the number of CDOs went from $10 billion a month to over $40 billion a month in less than 90 days. than 90 days. It doesn't seem as if the announcement of severe problems correlated with the actions that were taken. I believe that the rating committees would include any information they believe relevant in their deliberations. Could you, as a follow-up, give us some more specific information as to what did in fact happen in terms of incorporating this research into the rating process in October of 2006.
OtherYes. On my time, can I simplify that? Because this came from, obviously, Moody's.com, Mr. Zandi and his team, very well respected. Could you, as part of that, actually do a chronology of what management did very specifically, how folks reacted to that report, because it's pretty dramatic. It uses the word the market's going to crash in 20 metropolitan areas. So if you could give a very specific timeline about who did what, when, when from the top levels on down.
OtherI will do that, and I should just add that I believe at this time, even with the analysis that Moody's Economy.com was producing, their expectations were far more moderate in terms of what was going to happen in the housing market than what, in fact, has eventuated. So I just want to make sure that there's no misunderstanding in the degree of downturn that they they were expecting at that time compared to what we've seen. One of my concerns, which is not peculiar to the financial industry or to rating agencies, but seems to be endemic across our culture, is the avoidance of warning signs until the situation degenerates into a catastrophe, whether it's the failure to see the consequences of new technologies in deep water. what are petroleum extraction but not changing safety and response capabilities
[46:59]
Questioneror some of the signs that have led to the now the financial collapse. The first panel made up of people who all had had experience at Moody's gave a number of reasons why these warning signals were not acted upon. Those included the desire to increase a market share, the lack of ability to walk away from a deal, the lack of human resources, to keep pace with the rapid increase in the number of CDOs that were being evaluated, the lack of adequate independent research capabilities, the fact that the banks were misleading the rating agencies and manipulating the process. Those were some of the rates. the items that were listed. Do you concur with that list and are there other items that you would add to the list of why were the warning signs missed?
OtherThere are some things I would concur with and some others that I would not. And to highlight two that I think are important. First of all, we agree that having a robust, independent research and credit policy function is important. And And we have made changes in both the number of individuals and the independence of the credit policy function over the past three years.
QuestionerExcuse me, could I ask? One other issue was the fact that the committees that were doing the rating seemed to be devoid of people either from the real estate industry or from the banking industry. and therefore had little personal capacity to evaluate what was happening in those areas. Have you taken some steps to broaden the pool of background on the rating committees?
OtherThat, again, in the category of lessons learned, greater cross-disciplinary expertise in rating committees, I think is important. is important and we have made important strides in accomplishing that. And I think we've made very good progress.
QuestionerCould you give us some information on that subject as we asked the first panel for what was the status of those rating committees during the period of 05 forward?
OtherYes. With respect to being unwilling to walk away from a deal, I believe, was one of the comments that you had related. I simply disagree with that. We did not rate hundreds, probably thousands of residential mortgage-backed securities tranches, particularly the junior securities, even though we looked at them. Our opinions were not such that the issuers wish to have those opinions, and we did not rate those. We have sat out entire market sectors for credit reasons, where we have credit concerns. And that is because the ratings quality is paramount.
[50:39]
OtherWe don't always get it right. Predicting the future is an uncertain process. But I think that there has been a misunderstanding of our willingness to stay out of markets where our credit opinions are more conservative or we have credit concerns. What about this issue of misleading or manipulative activities by banks? Well, certainly, if we're aware of anything that is misleading or manipulative, we would not use that information or pursue rating a transaction with an institution that's providing that. Well, the testimony that we had was that the banks would not disclose information which was requested, and the analysts didn't feel that they could push back against the banks to make that a requirement of their issuing the rating. Our methodologies are, I believe, clear in terms of the information that we need to rate an instrument And I believe that we pursued that information consistent with our methodologies. There may be additional information that would be interesting to review, which may or may not have an influence on our thinking on credit, but certainly we would look to have all of the information that is consistent with our methodological approach.
QuestionerMr. Buffett, this is a broader question, but I know you have an excellent reputation of being the risk manager for your firm and that you feel, as you've said today, that you feel that's a principal responsibility to the CEO. Why do you think that as a society we seem to have missed so many signals across a range of areas?
WarrenWell, but rising prices and discredited Cassandra's from the past, blunt sensitivity, and judgment, even if people who are very smart. I mean, initially, my old boss, Ben Graham, you say you get much more trouble in investments with a sound premise than with a bad premise, because the bad premise you recognize immediately doesn't make any sense. When you have a sound premise, namely the Internet's going to be very important and eyeballs are going to be important and all of that, initially that it makes a lot of sense. After a while, the rising prices of all Internet stocks cause people to be able to raise billions of dollars for things that are nonsensical. So a home is a sound investment. I mean, it is 66 or 67 percent of people are going to want to be in one. And if you believe house prices are going to go up next year, you're going to stretch to buy one this year. And the world enabled people to stretch.
[53:40]
WarrenAfter a while, rising prices became their own rationale. And people decided if buying one house was a good idea, buying three houses was a good idea. If buying a house you're going to afford is a good idea. Buying a house you can't afford is a good idea because it's going to go up in price. And people who lent money said it doesn't really. any difference whether the guy's lying about his income because if the house goes up in price, we'll get our money back anyway. So rising prices are a narcotic that affect the reasoning power of up and down the line, people even that should have the experience. Isaac Newton participated in the South Sea bubble originally got out, and then he couldn't stand prices going up any longer, so he went back in and got cleaned, you know, and this is a fellow that generally was regarded as being pretty bright. So it, it, rising prices are eventually We had up in farmland in the Midwest, and it was a worse recession for us than this housing recession because people just felt they're not making any more farmland. There are going to be more people, they're going to eat more, farmland's going to get more productive. And the rising prices eventually created their own destruction. On my time, just quickly, but okay, but it's a narcotic, but don't we expect that regulators, credit rating agencies not partake of their narcotic? Isn't that their role?
QuestionerWell, you would hope so. But it's not easy to avoid.
WarrenWell, still, but you don't want your police trading and crack. I mean, you want them stepping back. Yeah, and we had Chairman Greenspan talk about, you know, irrational exuberance in 1996. But with all, with the power of his podium and everything else, we had a great internet boom after that.
QuestionerI know. That was the nature of my question is about who's responsible. Regulators, shareholders, boards, management, someone must be. I'll turn it back to. I want to ask a different question, Mr. McDaniel. During this period of the last five years, how frequently did representatives of various regulators, from financial institution regulators to the SEC, visit Moody's to talk about your rating methodology and to inform themselves as to what it was that you were doing? They're the ones who have imposed regulations requiring the use of your rating methodology and to inform themselves as to what it was that you were doing? They're the ones who have imposed regulations requiring the use of your rating services.
[56:01]
QuestionerHow close to supervision or at least monitoring of activities did they maintain? Pursuant to the Credit Rating Agency Reform Act of 2006, which became effective in, I believe it was September of 2007, There has been multiple inspections and reviews of our rating processes and practices and practices by the Securities and Exchange Commission.
OtherPrior to that period, the oversight was less intensive because there was not a regulatory framework that the SEC was operating under for an inspection and review regime. Prior to that legislation, are you saying they did not seem to think that they had some responsibility having mandated or given strong incentives to use the rating agency's products as part of the management of regulated activities that they had some responsibility to be aware of what that rating agency's constituted and how it was being assembled?
OtherI can't speak for the Commission, but I believe that the regulatory oversight opportunities were more limited prior to the legislation passing, and so they were not as extensive in their oversight of Moody's or the industry.
QuestionerThank you, Mr. Chairman. Thank you very much, Senator Graham. Mr. Wallison.
OtherThank you, Mr. Chairman, and thank you both for coming here, even one under compulsory process, but voluntarily still. Thank you. Let me start with you, Mr. McDaniel, and you were here this morning for the earlier panel. I heard most of the earlier panel, not all of it. I just was wondering whether you heard anything about your company that was a surprise to you or you did not know.
OtherThe issues that were raised by some of the individuals who are more critical of the company, I have heard before, and in fact we have investigated those issues previously, including through use of an external law firm, and found the concerns that were raised to be without merit.
OtherWell, there was this question I thought of enhanced, what you, I think, referred to when you were talking about enhanced analytical integrity. I think you were getting at the point that there were pressures, perhaps, on the talent that you have, the analytical talent, to produce ratings. Is that what you meant by enhanced analytical integrity? And what did you do to prevent that from happening?
OtherIn the context of my prepared remarks with respect to enhanced analytical integrity, I was referring to some of the actions that we have taken since 2007 to separate, for example,
[59:36]
Otherour credit policy function from the line of business ratings analysts, to have more cross-disciplinary participation in the rating committee process, and to create first. separation of any person who is involved in commercial activities for the firm from people who are involved in analytical activities. Let's talk specifically about this one issue, and that is, are analysts now permitted to talk to issuers or the representatives of issuers? Is that still permitted?
OtherYes, analysts do speak to issuers. And you're not concerned that there are pressures brought on them as academics or people who are academically inclined by people who are much more ambitious and forceful. That is not a, you don't see that as a problem. I think the communication between an issuer of securities and an analyst of those securities is important and should continue. The analysts may have questions about financial information or management strategy at the issuer. The issuer's future plans with respect to its capital structure, etc. So I do think those communications for purposes of creating the most predictive credit ratings we can produce are useful. Is there a manager who oversees the analysts and can be available for discussion of these issues? There are managers who oversee our analysts, yes, and they would be available.
QuestionerLet me ask you one final question, a very general one, and that is what is your view? of what caused the financial crisis?
OtherIn terms of direct causes, certainly the weakening of the housing market, the softening of that market, and then importantly, the very rapid tightening of credit for mortgage borrowers who needed to refinance in particular, greatly, exacerbated the issue that the sudden tightening of credit in the midst of a softening housing market I think produced the kind of large and rapid problem that we saw. So it's principally a problem of people not being able to finance, refinance, which caused failures? I think that was an important contributor. It acted as a catalyst.
QuestionerMr. Buffett, we've had housing bubbles before, quite a few, and other kinds of asset bubbles before, most recently an oil price asset bubble. This one was really quite special. I want to press you a little bit on this because I'd like to get your sense of why this one was special. Why did it get so large? Why did someone, with your astute knowledge about the economy, not see that this was an extraordinarily different bubble from one we've had before?
[1:03:03]
WarrenWell, I wish I could give you a good answer to that. It was really the granddaddy of all bubbles, and it affected an asset class of 22 trillion. You know, I mean, it was, it hit everybody. Mr. McDaniel mentioned people refinancing. I mean, they were betting on the fact that the following year that they couldn't make the payments they could refinance. And, of course, the figures show that by the hundreds and hundreds of billions that happened. But when it gathers momentum, the Internet bubble went further than I would have thought it would have. We did have that farm bubble in Nebraska where, you know, things went crazy for a while. And the early Cassandras do look kind of foolish as they go along. And when your next-door neighbor is making money, you know, very easy by buying a second house, you know, with very small down payment, after a while, it sort of gets to you. And maybe you figure you should be doing it, too. It's been a history of bubbles. I mean, I never understood why tulips were worth what they were back in, you know. But for you in particular, and you've had many years to watch our economy. And to economists in general, sharply rising prices are a signal that something is peculiarly going on in the economy. Well, you saw the prices rising very quickly, but you still didn't think that this was something that could eventually collapse. I didn't think it would pop like it did, no. I, interestingly enough, in 2005, and six, and I believe I've got the time period right, I get offered businesses for sale periodically. A significant percentage of the publicly traded home builders, one way or another, let it be known that they would like to sell out to Berkshire Hathaway. And looking back, I should have figured out what I didn't figure out.
QuestionerWere they asking more than once?
WarrenIt's interesting. I never heard from them, you know, in many decades in business, and all of a sudden, three or four of them showed up on the doorstep. You were once an owner of Freddie Mac. Right. So you are familiar with how Fannie Mae and Freddie Mac operate. Do you see their activities as having any role in the growth of this bubble?
QuestionerWell, I think they were doing what they were instructed by Congress to do to a great degree. But they took on a week or four. weaker forms of mortgages in greater amounts. I mean, that's been covered in some of the reports. And so they also bought, you know, they would require a 20% down payment, but then they would buy mortgage insurance from other entities.
[1:06:03]
WarrenAnd I've looked at the profile of some of those loans and material I got from the mortgage guarantee organizations. And frequently, a significant percentage of the time, more than 50% of the income of the borrow was going to mortgage payments. That's not sustainable. But whereas they were laying that off with a mortgage guarantee insurance company, they were still, in effect, helping people participate in something that was really, unless housing prices kept going up, was going to lead to big trouble.
QuestionerWhy did you sell your Freddie Mac stock?
WarrenI sold it for several reasons, but I think we were the largest shareholders of Freddie Mac. And at one point, the, well, it became apparent they were getting more and more entranced by trying to report increased earn every quarter. And any financial institution that tries to do that, in my view, is going to get in trouble sooner or later. And they became quite interested in that particular, having that happen. They also, as I remember, it was either RJR bonds or Philip Morris bonds, but they bought some bonds that had nothing to do with housing at all. And here they were using what was in effect the government's credit to enlarge the size of this hedge fund type portfolio. Now with some corporate bonds that had nothing to do with housing. And I just figure if you see one cockroach, there's probably a lot of a lot more in the kitchen.
QuestionerDid you follow Fannie and Freddie enough to know that they had affordable housing requirements?
WarrenOh, sure, yeah.
QuestionerAnd did you know the size of those affordable housing requirements?
WarrenAnd of course, they were predicated on being able to use the tax credits that were involved, and they set them up as assets on their balance sheet. And of course, they have no income now. So those became very dubious assets.
QuestionerBut were you aware then that they were buying the kinds of mortgages that they were buying in order to comply with the affordable housing requirements?
WarrenWell, I certainly knew they were. They were mandated in many of their activities by Congress. No question about that. And they were also trying to serve Wall Street, and that's a tough balancing act.
QuestionerHow much time do I have left?
OtherFour minutes and 51 seconds.
QuestionerYou are quite famous for saying, among other things, and this isn't the only thing you're famous for saying, among other things, and this isn't the only thing you're famous for, but you said that
[1:08:21]
Questionerthat credit default swaps are financial instruments of mass destruction. And yet it's recently come to light that you actually participate actively in that market.
WarrenYeah, I think I actually said derivatives are financial, potentially. And I think that used improperly as they almost are certain to be, because of what they provide people to trade in them and what they provide in the way of increased leverage that's not obtainable. in other ways. I think that they have, they pose system-wide problems.
QuestionerWhat do you use them for?
WarrenI use them to make money. If I think they're mispriced, I buy them.
QuestionerBut you are, these are credit default swaps or other kinds of...
WarrenNo, we've never bought a credit to false swap. We've sold credit default swaps.
QuestionerYes. We sell...
WarrenYou sell insurance.
QuestionerWe sell insurance.
WarrenWe sell insurance. Yeah, we sell it on municipal bonds. We sell it. Yeah.
QuestionerAnd then do you, do you lay that off?
WarrenNo. You do not hedge insurance?
Questionerthat.
WarrenNo, I never lay it off. So you do... We sell insurance.
QuestionerThis is much like what AIG did, right? They didn't lay off.
WarrenI don't think it's much like it. But we sell credit insurance.
QuestionerNo, we sell auto insurance. Now we sell auto insurance, and AIG sold auto insurance, too. I mean...
QuestionerOkay. All right, I have no further questions. Thanks very much.
WarrenCould I bring up one point in connection with...
QuestionerSure.
WarrenBecause it gets back to a point that was made earlier about the laws getting on the books and never getting changed. If you go back, back to the late 1920s, we had a bubble then, and it was in stocks, and it was partly caused by extreme margin by people that really didn't know what they were doing, 10% margins. And they had commission hearings after that, and they decided that this was a societal problem. And Congress gave to the Federal Reserve to the authority to regulate margins, and they said this is important. The Federal Reserve still has that authority, as I understand it, you know, 70 plus years later. What we put in derivatives and total return swaps, you know, at that point you could borrow 100% of what you own. And so we sit here with a system, and I brought this up a half a dozen times, and sometimes with people in Congress, and I say, what in the world are we doing when we say the Federal Reserve should have margin requirements, which I believe now are 50%, and you can go to it and get a total return swap and borrow 100%, or you can buy S&P index futures with a tiny percentage down.
[1:10:44]
QuestionerI mean, it is something that should be addressed. I thought you are Or maybe I misread this in the newspapers, but I thought your problem with some of the legislation that is going through had to do with the fact that you didn't want to put up the collateral, which substitutes for the margin. In terms of contracts that were negotiated several years ago, there was one price for collateralized contracts and another price for uncollateralized.
WarrenWe simply said, and isn't we, Coca-Cola, Anheuser-Busch, thousands of companies negotiated under that basis. We say if we're required to substitute an uncollateralized contract and make it a collateralized contract, before we send that money to Wall Street, we should get paid for the difference in those two types of contracts, because they are two different contracts, just like changing the price or changing the maturity, and there's a very significant difference in price, and not only we, but hundreds of end users would be required to send money to Wall Street firms, contrary to the contract they originally negotiated and contrary to the price differential that existed between those two types of contracts.
QuestionerSo you don't have any objection to doing it in the future when you want?
WarrenNo, no, not in the least. I don't even object to. I object to, I object to selling one kind of a contract and having changed to another kind of a contract without getting paid.
QuestionerOkay, thank you. And Mr. Walson, if you can flip that mic off? Thank you. Thank you very much, gentlemen, for joining us. I'd like to start with Mr. Buffett, largely because my 90-year-old mother is watching and she'd be very disappointed in me if I didn't acknowledge your seniority. There you are. I take it that one difference between AIG's selling of credit insurance and yours is that you charge enough to cover the risk that you're undertaking. Is that fair to say?
WarrenThat's fair to say, but additionally, we only take on risks we can handle ourselves. So we only have about 250 contracts or so total. And if everything goes wrong, we can easily handle it. And that was not the case with AIG.
QuestionerIndeed, it was not. Let me, I want to address a general question, which I've sort of been putting at a lot of these hearings, about how we might restructure the incentives in the market system to try to avoid these kinds of crises in the future. You said, Mr. Buffett, that you liked this business at Moody's because it had pricing power, it was a natural duopoly.
[1:13:11]
QuestionerThis gentleman Colchinski, who testified a little earlier today, who's a subordinate of Mr. McDaniels, said that in many ways, the incentives for rating agencies have become worse since the credit crisis. There are now more rating agencies, and they're all chasing significantly fewer transaction dollars. The new controls put in place by regulators are too weak to significantly alter this dynamic. And then there's a quote that you also had in your testimony that you gave privately to our team. Market systems produce strange results, and Wall Street in general, the capital markets are so big there's so much money that taking a small percentage results in a huge amount of money per capita in terms of the people that work in it, and they're not inclined to give it up. And then one last quote I want to read to you, but I will tell you that quote, whenever I hear the terms modernization or innovation in financial markets, I reach for my wallet, it's usually what they mean is revenue producing. So we've seen a number of things go on in the marketplace. And you've also said that everyone should have a lot to lose in this marketplace. Well, really, in this securitization process, we've discovered through the course of our hearings, that really almost everybody involved has nothing to lose. The mortgage brokers who originate the mortgage get paid a percentage of the mortgage they originate without regard to the consequences if it succeeds or fails. The bankers who put the deals together, the mortgage-backed securities, are getting a percentage of the deal. The lawyers who write the prospectuses, the auditors who, accountants who audit the books, and the credit rating agents. who rate the credits are all basically paid in cash at the conclusion of the sale of these securities, really without any significant consequence to whether they actually do what people represent them to do, or they fail. And one thought that some people have suggested is that rather than pay all these market participants in cash, that you might increase the likelihood of diligence being properly done, properly done if you paid them in the securities themselves. So if you're getting whatever, 10 basis points of the dollars, give them the security to booties, so that you know that you're going to live with that security for a long time. You're going to be long in it. You can bonus the people that did the job with the same security.
[1:15:36]
QuestionerIf they succeed, they get 7% interest per year for 10 years, then they get their money back. What do you think about that idea?
WarrenI like it. put it in a deferred account and have an index of all the things in which they participated become the index factor that's applied to that deferred account when it's finally paid out at some point. You have to, I think the most can be achieved actually by getting at the very big institutions, the CEO and the boards where they've got real downside. But I can tell you, I was at Solomon almost 20 years ago, and trying to put in a new compensation system in Wall Street can be very difficult. but I don't retract any of those earlier remarks. I agree with them.
QuestionerWell, I asked it of Jimmy C. Case of Bear Stearns, who, Cain rather, and he said that that's a great idea, but they're not going to like it, is what he said. You know, so, I mean, I guess, it seems to me that, and I want to go back to here to what happened at Moody's to some extent. Because really, a hundred years ago, you know, John Moody started raiding railroad bonds. railroad bonds, which you know a lot about. Relatively simple instruments. Now Moody's is rating exceedingly complex instruments. And some of the financial incentives, maybe I should turn to Mr. McDaniel on this question, some of the financial incentives, it seems to me, are skewed in favor of your properly rating, besides the fact the obviously glaring one that issuers pay. But in your pricing, I learned from our investigation that on RMBBBB, on residential mortgage-backed securities, you charged 4.75 basis points for those tranches that were rated senior of the dollars in those tranches, and 3.50 basis points for the tranches that were rated subordinate, which it seems to me gives a skewed incentive for you to put more dollars into the senior tranches and less dollars in the subordinate tranches because you're going to make almost 40 percent more per dollar rate. in the higher rated ones, which is similar to a difficulty we've discovered in the mortgage brokerage situation where mortgage brokers sometimes were compensated at twice the rate as the percentage rate for generating a mortgage that had a higher interest rate payable to the lender than a traditional mortgage, which then incentivize them twice as much to direct borrowers into subprime mortgages and high interest rate mortgage. who might otherwise qualified for regular traditional ones.
[1:18:16]
QuestionerMr. McDaniel, do you think that's a problem and why, if you could tell us, did you actually structure the fees payable to Moody's in that way that gave you more if you rated them senior than they would if they were subordinate?
OtherWell, I think as you heard from the panelists earlier today, first of all, they were not aware. of a difference in pricing in their deliberations or analytical work and rating committee work. And secondly, although I have not had an opportunity to do a comprehensive check, I did go back to look at RMBS applications in 2006 and 2007, and the basis point fees were identical for senior and junior tranches.
QuestionerWell, our people say that they changed it in 2007 to full. flat to 3.5 percent, which incidentally is a reduction in pricing power, 3.5 basis points for all the way across in R&S, starting in 2007 forward, but 2006 prior it was a differential. I was able to look at 2006 and it was identical in 2006 as well. As I said, I did not have a chance to do a comprehensive check of this. Maybe you could check that out and report to us on it. The other point, I think, is that you got nine basis points. for rating a CDO, which is, again, more than twice as much as you got for rating in RMBS, which is sort of unclear to me how that could be. And does that then incentivize you to do more CDOs? Because you do a billion dollar CDO, you're going to make almost a million dollars in fees. And is that, is it really that much harder to rate a CDO than it is to rate an RMBS?
OtherWell, I'm not a CDO analyst. analyst, so I can only respond with respect to the overall approach. And if there is an opportunity to charge fees that the market will bear, I think we would do that. We have fees that range from very, very modest, particularly in the municipal bond sector, small municipalities, to fees that are much more substantial for large corporations and complex securities.
QuestionerRight. Let me try, I want to press you a little bit on it. Mr. Buffett, did you have a comment on that?
WarrenNo, I was just thinking I was looking for the modest ones. I haven't found them yet. Modest fees that they referred to it.
QuestionerRight. There aren't too many. I don't seem to find them either. Looking back to this chart that Commissioner Graham brought in front of you, it strikes me that when you look at this, In the face of contradictory information, the actual number of deals rated in both CDOs and residential mortgage-backed securities goes up dramatically.
[1:21:22]
QuestionerAnd really, even after you've had four or five major downgrades, I mean, significant downgrades, you're still rating a whole bunch of deals that come forward. And I think that, I'll sort of give you a pass to some extent on nobody knew that that. that the market was going to go down as fast as it did, and everybody was basically, I don't remember what your term was, Mr. Buffett, that everybody was believing in this bubble. But once you get contradictory information, don't you then have an obligation not to go forward? And to be honest with you, it looks to me, given now that there's so few transactions in the marketplace, that what you were really trying to do was get these deals done so you could mop up the last bit of the gravy before, they took the plates away. I mean, this is not, these deals are not out there anymore. There's not nine percent, nine basis point fees to be made on billion-dollar CDOs every day anymore. And the fact that you did it in the face of contradictory information seems to me be highly troubling. Do you have a thought on that?
OtherAs long as as securities are being offered to the marketplace, I think we have an obligation to try to offer our best opinion on those securities. So whether the markets are active and robust or whether they are quiet, what is coming to market, I think we should attempt to offer an opinion on. We obviously want those opinions to be predictive. We want those opinions to incorporate all information that we think is relevant and incorporate our best judgment. But I do think we should try to offer the opinion.
QuestionerBut they weren't any more predictive. Were they, in fact, they led to downgrades just as significant. as they did prior to that. Is that not correct?
OtherYes, Mr. Angelius. I don't know. I know you do. So do I. There are two Greeks on this committee, a gentleman, which is a little bit dangerous for all of us here. But Mr. Buffett, but Mr. Buffett, do you think that that, I mean, do you fault the management of Moody's for at least that? I know you're reluctant to give them fault. But in the face of this contradictory information, how is it that they went forward and continued to rate these securities essentially know differently than they had been doing in the face of the bubble?
OtherCan I say that what I, the reason I was waving my hands, I want to put this from perspective. Offering opinion is one thing. Offering opinion that their AAA is quite another.
[1:24:02]
QuestionerSo just to frame this question on my time, I think in 2007, $500 billion of R&BS. was rated AAA, about $100 billion plus after July 07 when you began to do the downgrade. So different seeing offering opinion, which may be this isn't rateable, shouldn't be rated investment grade, and then, in fact, rating an investment grade. Rating at AAA, and then, of course, they were then subsequently downgraded, even those later new issuances. Mr. Buffett?
WarrenYeah, well, I don't know. It took place internally there, but it's just from listening to this and what I see here on the chart and so on, it looks like they tweak their model when they should have gone at it with a meat axe, basically.
QuestionerRight. And it is sometimes difficult for people to adjust their thinking that much in a short period of time, but they should have gone at it with a medex.
WarrenYeah.
QuestionerOkay. Especially if they're on narcotics, correct?
WarrenWell, that's right. I mean, there are too many mixed metaphors here on occasion. But I guess I'd like to ask you if I could. I know you've testified in your internal testimony that you thought that the government made the right decision in backing up these companies that the markets really needed reassurance at the time. This is a more generic question not having to do with Moody's. But there are many who believe that that demonstrates the breadth and scope of this crisis, that, you know, we've had so many other crises. I mean, Enron was the seventh largest corporation in America. It went bankrupt. The tech bubble happened. A lot of other things have happened in the last seven. 70 years, and none of them required trillions of dollars of taxpayer money at risk to bolster the private sector. And yet you feel that it was necessary at the time. Could you elucidate?
WarrenI do. In September of 2008, you know, our financial system basically came to a halt. I mean, you had 30 million Americans with their money and money market funds comprising three and a half trillion, which close to half the deposits of the banks. And in the first three days of that week, following Lehman, 100,000. and 70 billion flowed out. Interestingly enough, that was all institutional. Individuals hadn't caught on yet. But when people, 30 million people start worrying about whether their money market funds are going to be break the buck. When you've got commercial papers stopped in terms of issuance, when you have, a little later, we sold a
[1:26:32]
Questionera treasury bill due in April of 2009, we sold it in December for $5 million and $90 when you were going to only get $5 million in April. So at that point, your mattress wasn't even good enough. I mean, a Treasury bill was $90 better than a mattress. So it was a paralysis of the system, and the American people knew that only the government could pull us out. They didn't trust anybody else, and the government had to act, whether they acted perfectly in every case, who knows. But the important thing is they acted. Okay, but now we're going forward, and part of what we're to do here is to evaluate what happened in the financial crisis and although we're not proposing remedies, certainly a lot of people are concerned about the debt that's been taken on to finance this bailout and so forth. What do you do in the future to avoid this occurring? By the way, go ahead and answer Mr. Buffett. If that's time, if we can let Mr. Buffett answer, we would want your answer.
WarrenYeah, the two best things I know to attack are leverage and incentives. I mean, I don't want to, you're going to, you've got a market. system and, you know, you can't rearrange the whole thing, but you can change how people behave in one case by incentives, and then secondly, you just tell them, you know, how much rope they can use by the amount of leverage they can have when they're, particularly when they are getting the benefit of government guaranteed money.
QuestionerWell, exactly, and you, let me just find one little follow-up, and that is your company, for example, has huge cash cushion, which you like to keep because it puts you in a, in a protected, safe position to take advantage of opportunities. A lot of other people in this financial institution area did not do that. They ran every capital arbitrage possible to avoid holding back as much capital. And so that seems to me to be a related problem.
WarrenYeah, well, the AIG derivatives contracts, you meant were to get around capital requirements in Europe. I mean, 300 billion of it. So, you know, there are a lot of abuse. And if you let those instruments exist in that form and let people use them in an unlimited manner, they will get use in an unlimited manner.
QuestionerThank you very much, Mr. Georgia. Thank you very much, General. All right. Let's move on. Ms. Murren. Thank you. Thank you both for being here. Mr. McDaniel, I have a question for you about the events of the crisis.
[1:28:54]
QuestionerAnd when you look back at the financial crisis, I wonder if the requirement, the legislative requirement that asks certain investors to invest only in rated securities, if those requirements had not existed, existed. How would your business have been different? Would you've had to compete on different terms and would you have had to reward people within Moody's differently?
OtherWell, I don't know exactly how the business would exist if there were different or lesser regulatory uses of the ratings. Nonetheless, I am supportive of a reduction of use of the ratings. of use of ratings in regulation. I think, I think the use of ratings and regulation offers rating agencies a basis for competing other than on the quality of their ratings. They can compete on the, in effect, the certification that they have as a regulatory approved rating agency. And I think that rating agencies should either prosper or not prosper based on whether market participants value the ratings and value the rating opinions and research that accompany that. With that in mind, there were comments from some of the individuals that were here before this panel that suggested that they could not determine if there was a connection between their ability to get the ratings right, their words, and their actual recognition within the firm. Do you think that's true? We certainly try to reward people in terms of their position in the firm and their compensation based on the quality of their work. It is a business in which it can take a long time to evaluate the ultimate performance of securities, but their research, their preparedness for rating committees, their their the robustness of their reasoning are things that can be judged and we very much try to do that. Those things are process oriented though, not outcome oriented necessarily. The outcomes are able to be measured at a broad level statistically to, I think, a strong outcome. It is more difficult to judge an individual. performance, especially in the short run, on a very limited number of credits. And so it is easier to measure this at a broad level than at a narrow level. Thank you.
QuestionerMr. Buffett, do you think that the investing world would be a better place if everyone had to do their own due diligence?
WarrenWell, I certainly think at Berkshire Hathaway, it's better. But there are people that aren't equipped. I mean, the banking authorities, insurance authorities,
[1:32:08]
Warrenprobably need to rely on some kind of standards to make sure that people don't go totally hog wild in terms of how they invest insurance funds which belong to their policyholders. But in the end, we don't use ratings. I mean, from my stand, well, what we really hope for is misrated securities because that would give us a chance perhaps to earn a profit if we disagree with how the agencies rate them. There's one ironic. point, I should mention, if there were 10 rating agencies, all equally well regarded, all acceptable to the market, and you only needed one on when Berkshire Hathaway's bond, we could have any one of them, those 10 would compete either on price or laxity or both. I mean, they would be out there trying to get our business, and they would try by price, but they might also try by laxity. You can argue that if there was just one rating agency, they would have no reason to compete on either price or laxity. I mean, independence can really come with strength in the business. Ben Franklin said it's difficult for an empty sack to stand straight. So if you really had this situation where there was a lot of competition, I'm not sure that the rating agencies would be as independent, actually, in coming to their credit conclusions as they are.
QuestionerI would hate to differ with you. But if you look at, for example, equity rates, for example, equity research. There are a number of boutique shops that are specifically known for the quality of their research, and they do not engage in investment banking activities. So they don't have as much of a stake in the origination process. And to me, there's some parallel between this area of research and some others. So I guess my question really is, if you change the way people get paid, you know, do you end up getting a different outcome? So that was really in the nature of where I was headed with this. But I actually have an off-top question for you, Mr. Buffett, and that is I know that you've been largely a hands-off investor for Moody's, but I was curious about the due diligence process in your investment in Goldman Sachs. And if you could talk a little bit about your conversations with management there and how that decision was made.
WarrenWell, that decision was made in September of 2008. We'd been approached by just about every firm, at least every firm that went under, about putting money in. And when Goldman Sachs was willing to take money on terms I found satisfactory,
[1:34:47]
Warrenwhich had not been the case even the week before, I came to the conclusion that unless the American financial system totally fell apart, that it was going to be a sound investment. And I had far more confidence in their risk management than I had in some of the other Wall Street firms that had come to me earlier. And again, if the system had fallen apart, if the Federal Reserve had not acted, in terms of commercial paper and the money market funds and all, everyone would have been toast, I think, basically. But I came to the, my basic conclusion was that the American government would do what was necessary to get the engine started again. And if that was the case, Goldman Sachs was in fine shape. But they did change the terms they were willing to accept for your investment as time went on.
WarrenYeah, prior to the middle of September, you know, they would not have paid us what they, remotely what they did, pay us for that preferred stock and the warrants, whenever it was September 22nd or 23rd or sometime, in that time frame. At that point, they not only wanted the money, but they wanted a show of confidence, obviously, and the fact that that the world wasn't going to come to an end financially, and I didn't think the world was going to come to an end financially because I thought the federal government would act. I mean, I just thought it was so obvious that it had to, and only it could do it, and I felt that our $5 billion would not be in any danger at all, and the terms were attractive, and there were a lot of other things that were attractive then, too, but I made the decision that that was a good use for the $5 billion.
QuestionerThank you.
OtherThank you. Mr. Holtz-Sakin.
QuestionerThank you, Mr. Chairman. Thank you, gentlemen, for spending time with this today. Mr. McDaniel, in your opening remarks, you were very forthright about the inherent conflict between providing ratings to the market and running a public company for profit and the incentives that issuers have to use the outcome of your rating process. How do you manage that conflict at Moody's? What do you put in place to keep that under control?
OtherWell, from my office, I think it's important to emphasize and reemphasize the fact that we are trying to create long-term shareholder value. And I think the way to do that is to have credit ratings that are of high quality and predictive over time. That is why the problems we saw in the mortgage-related.
[1:37:33]
Othersecurity sector were so devastating to the firm in addition to the consequences for the larger economy and to households in America. Beyond that, though, we have structural structural components of the firm that are designed to insulate and protect the analytical process from some of the financial and commercial interests of the company. Again, including independent credit policy function. We've also recently created a separate commercial organization in the firm that is separate and apart from either credit policy or the ratings analysts in the lines of business. And to be clear, those are two recent changes in response to the problems you have? The credit policy function has existed for many years, but we've enhanced that function in terms of its independence in 2007. And the commercial group is a more recent introduction. We also have formally separated the rating agency from our other operating businesses, non-credit ratings businesses. So those kinds of actions, I think, are useful and important, not only for our own processes, but to be able to turn around and demonstrate that those processes are proper and being handled in the right manner.
QuestionerRight. So the quality of the ratings ends up being the key. And I think you said earlier that you want them to include all the relevant information and make them as good as possible.
OtherAbsolutely. So I am then very interested in this situation that occurred in 2007 where you had the residential mortgage-backed securities clearly up for downgrade and at the same time our rating CDOs based on the same underlying RMBSs and went ahead and rated them AAA. It doesn't seem like all the relevant information was brought into the rating process and how do you feel about that and in the risk it placed to your reputation, the quality of your ratings.
OtherI believe that all of the information we thought was relevant at the time was brought into the rating process, but obviously we had the problem of underestimating the extent to which the housing downturn was going to its magnitude and how widely it was going to affect home prices nationwide. So as a result, even though we felt we were including relevant information, we felt we were were using the best information we had available. in the rating committee process, it proved to be insufficient. You couldn't wait until you found out a little bit more from your R&S guys before you went out
[1:40:39]
Questionerand rated the CDOs? Or was the short-term pressure too great?
OtherI think the information that our RMBS teams had and their perspectives and opinions were available to other teams as they developed and evolved. I think we were trying to incorporate their changing points of view as we were looking at other securities related to the mortgage sector.
QuestionerWell, at least appears, with the benefit of hindsight, that there really was a rush to get this stuff done. And it strikes me as central to your role, and Mr. Buffett indeed said, you as a CEO, have to be your chief risk officer. And knowing the way in which these ratings were done and knowing when not to do them, wait and get more information. We heard from the panel earlier today about a great desire to learn more about the cash flows underneath the CDOs, but such a study was not done, and pressures from outside the organization to manage the market share, all of which were pretty striking testimony to a real effort to move things out for short-term gain at the expense of what turned out to be your reputation and your long-run value.
OtherWell, we simply, if we thought that this, the housing, the housing process, the housing process, problems and the collateral consequences from the housing problem, if we had thought they were going to be what they in fact have turned out to be, we would have had very different opinions on those securities. We just underestimated and dramatically underestimated the significance of the downturn.
QuestionerMr. Buffett, you've said that you're interested in long-run value and not short-term profits. Were you aware of the problems in the structured credit housing-related? construction credit ratings?
WarrenCertainly not sufficiently. No, we, to my knowledge, I don't think I've ever bought a CDO or a residential mortgage-backed security. Actually, we bought one recently here that we thought was mispriced, but it was not a field that I spent a lot of time on. It's just I was more interested in stray debt and equities. And were you satisfied with the risk measures, the internal controls at Moody's, and doing due diligence on all the products they provided ratings on? I had no idea. I've never been in Moody's. I don't know where they're located. I know their business model is extraordinary. They have the ability to price. I want to come back to that. Yeah. But isn't it at odds with being confident of their long-run value?
[1:43:31]
Warrenvalue to not know if they're doing due diligence for the asset they consider most important, which is their reputation? The long-run value basically was in their position as part of the duopoly that arose naturally over a long period of time. Independent of the quality of their ratings? Well, I'm in no position to judge thousands of ratings. I think they mis-rate us. They've got us a notch below where Standard & Poor's has us. So clearly, there's for improvement. But, no, I've watched their process. I've watched their process. They come out and they spend, and Standard & Poor's does too. They'll spend three hours with me. They'll go to all our managers, key managers and our insurance businesses. But three hours every year, and any question they ask me, you know, I give them the answer to. I give them my thoughts about the future, which I don't even with our own shareholders. They have been diligent in terms of what I have seen at the Berkshire Hathaway level. the Berkshire-Hathaway level. And in terms of our insurance, now, they also have this incredible pricing power. I think they ought to be doing it at a much lower price, as far as I'm concerned. And, of course, I think they ought to be rating us right up there where Standard & Poor's has us, but that's another question. And what is the source of the pricing power? What is the source of the pricing power? The source of pricing power is that if you're an insurance company, as an example, but if you're any issuer of securities, people expect you to have a Standard & Poor's and Moody's rating. And it's very, very, you know, small, the dollar spent as a percentage of the total bond issue or whatever you may be doing, but it's required. It's like an SEC filing fee. You know, I mean, basically, you're not going to come to market without it. And if the SEC doubles its price for filing fees, I pay it. If they triple it, I pay it. And there are certain things that are required as part of issuing securities. And in this country, an important part of the securities that are issued are required to have a standard and pores and Moody's rating attached to them, and often it's by statute.
OtherMr. McDaniel, in your time and to your knowledge for your predecessor, has Moody's ever lobbied Congress or the regulatory agency to enshrine in statute or regulation requirement for ratings?
OtherNo, not to my knowledge. Just the opposite. We have been, we have spoken repeatedly, publicly, going back at least 15 years about the risks of including ratings and regulation and offering.
[1:45:58]
Questioneroffering our support for the reduction or elimination of the use of ratings and regulation. I would say that they are required by regulation in many of the situations. Great for pricing power. Yeah, it is. But if they weren't, we still would have to happen. I mean, now the world may change, maybe different 10 years from now or 20 years from now. But there's no way, Berkshire Hathaway, even with a good reputation and all earnings and CPA reports attesting to the fact that the 20 billion in cash is really there and all of that sort of thing. week, we will not be able to issue a bond without a rating. So what I hear you saying is that from the long-term value perspective, it's that pricing power that matters, not the quality of the ratings, that the internal controls were not a great concern to you. Yeah, yield the gentleman an additional two minutes. And that the conduct of Moody's and Standard Ports for that matter through this episode was...
WarrenI'm not in a position to evaluate the internal workings of Proctor and Gamble. I would think you'd be a better position than most of us. No, we own a significant position in Procter & Gamble. I don't know what their internal controls are. I don't know how they make Tide, you know, and whether the processes are proper. We own a lot of Johnson and Johnson. They had a problem at the McNeil lab recently. There's no way I'm going to know about that. Over time, I think Johnson and Johnson will do fine. I don't think they're going to do everything perfectly, but I think, generally speaking, their management has done a good job, and we'll continue to do a good job. Thank you.
QuestionerI'm going to take a minute, so to probe this. Don't you believe that shareholders and boards, who shareholders elect, have a threshold responsibility for the proper conduct of a corporation? And let me add to this. I mean, forget the housing price miss. There's now a whole set of information here. SEC reports, extensive testimony, I might add, not just two or three people about the culture at Moody's that may have jeopardized the ratings quality. information that there were inadequate resources, inadequate pay. I don't think it's any secret that pay at the rating agencies that may be good for the bottom line revenue, but that pay was not sufficient to retain, to attract and retain the kind of quality of people we have. There's a meeting that Dr. Witt, who testified this morning, talks about that as the markets are coming apart in 0708, there's a big employees meeting and Mr. McDaniels there and talking about how we're going to get it back on track, be profitable, and a managing director after 307.
[1:48:26]
Questionerminutes of this. Finally stands up and says after about 30 minutes of this, this is Dr. Witt's testimony. One of our MDs from the corporate sector says, are you going to talk about how we're going to ever salvage our reputation? You know, rather than to say, gee, I didn't know, don't you think a shareholder with 20% coupled with three or four others that have 50%? Five of shareholders and the board have a threshold responsibility in regard to these kind of operations. And that's number one. And number two is knowing what you're you know today, are these matters of grave concern to you as a big shareholder?
WarrenI would say in terms of, in terms of the behavior of the credit agency, recognizing all their limitations, aside from the real estate bubble, I do not have a record of where they have been further off in their, in their ratings than I would expect a normal human beings to be. It's not about matter of ratings. Take a look at the SEC report. We posted it. We'll post it on our web. It talks about threshold issues like adequacy of resources, business considerations affecting ratings. Well, if we can't count on corporate shareholders, who can we count on that? Well, I'll go back. We own a very big chunk of Johnson & Johnson. In the papers in the last week, there's been a lot of material about some children product, the McNeil thing. Am I going to investigate that? No. I mean, overall, I feel the Johnson & Johnson management is going to do a fine job over time, and that they'll make mistakes and correct them. Now, if I see something, if I think they're overreaching, or doing certain things. If you see a cockroach. Yeah. I do not regard. If they have a problem with one lab, I do not regard that. They had a Tylenol problem many years ago, as you know. I mean, every may, I would say this today. We have 260,000 employees at Berkshire. Somebody's doing something wrong now. I wish I knew who it was, and I wish I could find out. There's a difference in that and systemic failure. I don't think it's been systemic failure. I think they made a huge mistake. Have you looked at the SEC report, at least the public one? No, I haven't. Okay. Mr. Thompson. Thank you, Mr. Chairman. Mr. McDaniel, much can be said about tone at the top. And so would you just tell me what outcomes or results you value most from your company? The somewhat similar to a remark I made a few minutes ago.
[1:50:54]
OtherObviously, we want to, I want to have a successful business, and I believe the way to have a successful business is to have high quality products and services, in this case ratings and related research. It does nothing for our business to focus on the short run and to cut corners. And as I've said, that's why it is so deeply disappointing to have had the experience that we've had in the mortgage-related securities that we've rated.
QuestionerSo quality of the product or service that you deliver would be the one outcome that you value most?
OtherYes, because I believe that leads to the long-term prosperity of the firm.
QuestionerYeah. So why then is quality not a major component in the compensation plans for the managing directors who rate these securities?
OtherFirst of all, I think it is. And we have adjusted our compensation programs over time in order to try and align high quality product and service with compensation. Our senior management team, the top senior most 40 individuals in our firm, now have as part of their compensation program, three-year performance share plan. And for everyone involved in the Moody's Investor Service rating agency business in that group, there is 50% of that plan is based on the statistical performance of our ratings over that three-year period.
QuestionerYou said now, when was that change made?
OtherThis was introduced at the end of last year.
QuestionerYeah, okay, so this is after the crash, if you will. And it's really an experiment. We will have to see how this works. The ability to measure rating statistically over a multi-year period is something we can do. And we think that it's going to provide good incentive alignment for our senior management.
QuestionerSo in keeping with the notion of tone at the top, then you would say that in your communications and your most senior team's communications with the rank and file of Moody's, it's clear that quality trumps market share.
Otheryear? Well, from my position, I have to be concerned with all different aspects of trying to manage a successful business. But for our more junior employees, their compensation are analysts and support analysts. Their compensation is in no way tied to the number of securities they rate or the number of companies they follow or anything of that sort. Or the share they gain in the market. Or the share that they gain or that we lose in the market. So the gentlemen who were here earlier were delusional about what objectives and goals they really had
[1:54:07]
Otheras they were working at Moody's? As I said, I care about market share. I care about market coverage, as much as I care about market share, even if that coverage is produced on an unpaid basis. I still want to have market coverage. But I also care deeply about ratings quality. And part of my job is to balance those interests properly and to communicate that balancing of interests throughout the firm in a way that individuals understand that the long-term success of this company has to start with product and service quality, ratings quality, research quality.
QuestionerMr. Buffett, much has been said. about regulatory or supervisory failure through this debacle. The SEC, O'FEO, you named the regulator that was involved. Any number of them missed. Other than over-the-counter derivatives, can you think of a major area of regulatory oversight that dictates major changes in our system?
WarrenWell, I would say that going beyond the OTC derivatives, I mean, I would think of a major oversight. I think that addressing the problems of disguised leverage, unwise leverage, which is really tough, but they're doing it with ratios is not the answer, it's not the sole answer. But leverage is what gets people in trouble. I mean, we run Berkshire that way. And when people stretch and they get rewards for it, they're inclined to. to stretch more. I think I heard some testimony in an earlier panel you had about, you know, whether having the objective of return on equity, whether that might cause people to do different things. Well, of course it does. People will do different things. And the easiest way to jack up return on equity is to leverage. And so addressing that, addressing it wisely, I think, is very tough. I mean, you know, but I think that that's the most important thing in the regulatory world.
QuestionerAre you as surprised as most Americans are that post-Enron, we could have off-balance sheet financing that would have been, perhaps, at the core of this collapse?
WarrenYeah, I don't know that it necessarily at the core, but I would certainly was surprised when Citigroup turned out to have SIVs, you know, in the many tens of billions, you know, which is just a way of jacking up leverage again, I was surprised. I mean, but now I may not have very much. read the 10Ks carefully enough or anything, but there certainly were no flashing signs that said we're using a bunch of leverage off balance sheet. And so I think that, I think you're always
[1:57:12]
Warrengoing to be fighting the human tendency to borrow more money than you should. And households did it because they thought that houses were going to go up next year. They really didn't think it made any of what their income was because they'd refi in a year or two. And it's just such a human tendency that you need something on the governmental side to balance that. counterbalance that.
QuestionerThank you very much. Before we go to Ms. Bourne, I just, can I just ask if we get supplied with a couple pieces of information? Can we have made available to us the board's evaluation of you, CEO? Do they do an annual evaluation? I submit a self-evaluation, which the board then reviews and discusses among themselves. Can you provide access to that to us? Yes. Okay. Secondly, can we also have access to any internal, comprehensive reviews that have been done about practices at Moody's, to the extent we haven't already received them, in other words, reviewing systemic breakdowns that might have been done? Have you done comprehensive reviews internally in the wake of all this? Well, we've done a number of reviews, and if there's anything that we haven't provided that's appropriate, I certainly would instruct our people to do so. And then finally, I think the company did a review with a law firm of Mr. Mr. Kaczynski's employment retaliation allegations. Can that be made available to us? I'm not sure. I don't know if there is a report on that or not. I believe there is. I believe there is. Check it out. If Mr. Klochinski agrees, I would hope that you would also. Can you please check it out? Thank you. I will check, yes.
QuestionerAll right. Mr. Chairman. Yes, sir. For the record, especially since we have witnesses in front of us, which we say you ought to know more about your business. and someone else's business, notwithstanding the fact you're looking at it from a different perspective, I would like to place on the record the fact that the commission will examine the assertion that we've made, which we believe to be accurate, that there were various rates charged for different tranches, and if need be correct, the record, and if not, be proud that we were right, but we're going to get the answer correct, one way or the answer. As I said, I did not have an opportunity for a comprehensive check on that. And neither have we, but we believed it to be accurate, so we're going to get to the bottom of it.
[1:59:35]
QuestionerThank you, Mr. Chairman. Ms. Bourne. Thank you very much, and thank you both for appearing before us. Mr. Buffett, I'm going to take advantage of your being here by asking you about derivatives and your views of them. As Mr. Wallison has said, your 2,000. and 2, Berkshire Hathaway shareholder letter, famously referred to derivatives, and this is, I believe, all derivatives, not just credit derivatives, as, quote, financial weapons of mass destruction carrying dangers that while now latent are potentially lethal, end quote. You also presciently said that they are, quote, time bombs both for the parties that deal in them and the economic sense. system, end quote. And more recently in your 2008 shareholder letter, you said that Bear Stearns collapsed demonstrated the time bomb of counterparty risk that you had earlier described. And I would ask that these two shareholder letters be placed in the record. They will be. I would like you to describe your view of the role that derivatives has played in the current financial crisis.
WarrenWell, they have accentuated enormously, in my view, the leverage in the system, the huge dependency on counterparties. And one of the beauties of the beauties of the stock exchange over years is that you've had now a three-day clearing system because people realize that if you have a contract and it's six months later that, that it settles that a lot of things can happen in those six months. In fact, I think the Kuwait stock exchange got into big trouble some years back because they had a very delayed clearing arrangement. And derivatives are contracts with sometimes unbelievably long settlement periods. Generally, we inherited 23,000 derivative contracts. I could have hired the 50 smartest PhDs out of of MIT to prepare some kind of report that would tell me the risk I was bearing and I would never I wouldn't have gotten the answer. I mean, it was impossible to get your mind around that. We had 900 counterparties. I couldn't pronounce the names of a couple of hundred of them. I mean, they were foreign institutions I never heard of. And in effect, the integrity of our balance sheet at January was dependent upon all of these people behaving at times in the future, which struck out to almost 100 years in a few cases. So the only answer was to get out of the business. I couldn't design a system that would enable me to know what the hell was going on.
[2:02:26]
QuestionerIf that was my problem with 23,000 of them, you know, I've read about vastly greater numbers that existed at Bear Stearns or at Lehman and something. I just think institutions can get out of control. And I don't think that's a good thing for the system, particularly when, if they're large enough, if they get out of control, it means that society gets disrupted in a very, very major way.
QuestionerWell, following up on that notion, I think you stated in your 2008 letter. that the Federal Reserve rescued Bear Stearns because the counterparty risk posed by its enormous position and derivatives would have created, quote, a financial chain of unpredictable magnitude. Is that correct?
WarrenThat's correct.
QuestionerAnd what happened, of course, I think in Lehman was that we saw an example about it. I think it was underappreciated. And I'm not saying I would have called it right either. But when Lehman, failed, an institution that was showing 15 or so billion of book equity. Now, sell it was real estate deals and a sum of that. But in the end, the debt of $140 billion or whatever it was is now selling for maybe $30 billion in the market. So that's $110 billion. That kind of money shouldn't disappear overnight. And with respect to the other large derivatives dealers, AIG, AIG, and the large derivatives dealers, AIG, and the large, large, you know, investment banks and bank holding companies that needed TARP money. Do you think that played a role with respect to them as well?
WarrenYeah, I think the government did the right thing in stepping in an AIG, but I don't think AIG should have gotten there in the first place. And AIG is, you probably know better than I, I think there was 300 billion of derivatives that were essentially designed for something called regulatory arbitrage, which was just a way of relieving the capital pressures on European banks because they got the AAA of AIG transferred over. Well, if you get enough of that sort of thing going on in a financial system, you're going to have a problem.
QuestionerWell, in light of the problems that you and the other people at Berkshire-Hathaway experience with the General Ray derivatives position, what's your view of the ability of these enormous derivatives deal? to successfully manage their companies in light of their enormous positions. For example, they hold millions of contracts.
QuestionerYeah. At year-end, 2009, the OCC said that J.P. Morgan's position was $78.6 trillion in
[2:05:23]
Warrenin notional amount, and can such enormous complex books of business be successfully managed by human beings. I think they're dangerous. I would say this. I don't think I could manage it. But it's hard for me to imagine a system. And it's hard for me to imagine a regulatory system that could supervise something like that. And of course, one of the ironies is that with only four big auditing firms in the United States, I will guarantee you that if you take two big firms that are audited by the same auditor, you will find different prices attributed to given derivatives contracts at the same time that the auditor attests to. I mean, it's mind-boggling. And the 23, you mentioned, are getting out of it, we lost $400 million in a very benign period with no pressures on us, able to exit, and that's why maybe Lehman lost $100 billion, but it's very dangerous stuff.
QuestionerYou've also pointed out that in your, I think, most recent, shareholder letter, the 2008 one that I'm referring to, not the 2009, that it's almost impossible for an investor looking at the financial statements of these big derivatives dealers to really know what their financial situation is.
WarrenYes, and I think if you added a thousand pages to disclosure, it would be impossible too. I try in our report because we only have 250 positions. I try to tell the shareholders what basically the positions are. And I think I can do that with, but that's because there's only a couple classes of them and I can describe them. And I think so that anybody that knows accounting at least can understand what I'm talking about. But I don't know how, I don't know how to read a 10K, whether it's 300 pages long or 3,000 pages long that can describe a million derivative contracts.
QuestionerNow, you're a very sophisticated investor. And I assume in going into derivatives contracts, you carefully examine what the embedded risks are, what the leverage is. I'm concerned that so many municipalities and other large institutional investors that may not have your sophistication have gone into these contracts. I'm concerned. that the embedded risks and the leverage aren't fully understood.
WarrenNo, I'm sure you're right. And, I mean, you had Orange County, you had Jefferson County in Alabama. But more importantly, if you go back a ways, when Bankers Trust was selling them to P&G. I mean, can you imagine bamboozling the CFO of P&G? So when you get these exploding type contracts, where if you had a given threshold,
[2:08:24]
Questionereverything gets multiplied by 10, or I don't even know why in the world they're needed. But those contracts are out there, and I don't, I think many times, the people that are buying them don't know what they're doing. There's been enormous growth in this market. The Bank for International Settlement said that globally the market amounted to more than $614 trillion dollars at the end of last year. There's enormous innovation that's been going on, financial innovation. There's enormous complexity in these contracts. I understand that there's an enormous complexity in these contracts. I understand that the they are very useful for hedging purposes. And I think that's a perfectly legitimate purpose. I think you need some speculators in order to allow hedgers to effectively enter into positions. I'm concerned about the enormous growth of purely speculative transactions in the market. And I wonder what your view is as to the economic benefit to our society from that speculation.
WarrenWell, I wrote a letter in 1982 to Congressman Dingell, giving my views when they were introducing the S&P index future. And I said there are legitimate uses for it, hedging out along positions and so on. But I said, overwhelmingly, it's going to become a gambling vehicle. And I would distinguish between speculative and gambling. Gambling involves, in my view, the creation of a risk where no risk need be created. Now, obviously if you plant a crop in the spring and you're going to harvest in the fall, in the fall, you are speculating on what prices are going to be in the fall for your corn or oats or whatever it may be. And you may lay that off on some other speculator. But that's a risk that the system has to take. You can't grow it in one day. But when you start wagering on stock index futures, I think that gambling instincts are very strong in humans. I mean, people went a thousand miles to a bunch of sand originally, and they built a whole city on it. And they would build a whole city on it. They would travel on planes and go to all kinds of things to do mathematically unintelligent activities. So it exists. States prey on it with their lotteries. And these contracts are made order for it because you can do it on a big scale and you can do it. And it's very easy to do. And, you know, you don't have to get out of plane. You don't have to break a sweat. You don't have to put down any money.
[2:10:58]
OtherYeah. And the more complex, generally speaking, the more complex, Generally speaking, the more profit there's going to be for the derivatives dealer. You can take that as a given. When I was at Solomon, originally you talked about interest rate futures, you know, fixed to floating or foreign exchange. And then they became known as plain vanilla contract because there wasn't any money in them. It got competed away. So they invented more exotic instruments and that's where the money was. Well, I would ask that the 1982 letter by Mr. Buffett to John Dingle be placed in the record. One last question. We have it. It's typed on a Smith Corona typewriter, apparently. That's our most piece of purchase. It's a carbon copy. Mr. Buffett, in your view, is the derivatives market still a time bomb ticking away?
WarrenI would say so.
OtherThank you. Mr. Chairman, I yield the Commissioner Holtzik in one minute. Thank you. Mr. Buffett, I really appreciated that testimony because what you said about the derivatives and your response to them was you needed because you needed to manage your balance sheet, in which case just got rid of balance sheets exposed. The unusual statement in the context of these hearings, we have heard again and again and again that whether it be a city group or a Fannie Mae, that they didn't manage the balance sheet. They just got overwhelmed by something so large that it could not have been imagined. And had everybody simply managed the risks on their balance sheets appropriately, something that large could not have emerged. And so it is important to come back to that. And I think that. I think it's important in light of this hearing because at the heart of the question that faces us today is the question of what was the management of the balance sheet of these rating agencies? Was the asset being managed their reputations? And if so, was due diligence done in pricing the most valuable risks, risks that are correlated with the most important thing going on in the economy? Or was effort devoted elsewhere to the ability to manage volume and take advantage of pricing power? Which asset managed? strategy was in place. Thank you. Go ahead. Mr. Chairman, I would yield Commissioner Wallinson the remainder of the time until the 2 o'clock end of the This portion of the... It's 2 o'clock, but why would we just say a couple minutes then? Oh, I kind of like the more dramatic way I said.
[2:13:22]
OtherWhich I might add it's 2 minutes, he doesn't think he gets much. Or a minute, which is an empty offer since it's 201. Oh, come on. Stop fighting, guys. Let me ask my question. Go. Look. Look, one of the issues that is central to this hearing today, it seems to me, is whether the problems at Moody's, and I think we don't agree there were some problems at Moody's, are systemic in the sense that they extend across the board throughout Moody's, or are simply unique to the housing mortgage area. And one of the ways we can address that is by looking at how successful Moody's or unsuccessful, Moody's has been in rating non-housing asset-backed securities. So, Mr. McDaniel, what I would like you to do is to assemble as much information as you can on the other kinds of non-housing asset-backed securities that Moody's has rated and give us a sense of the number of downgrades or even upgrades that occur from time to time in those securitizations. That way, we can compare the way Moody's operates as a general rule against what happened in the very unusual housing area, which as you pointed out, has shocked everyone, including the estimable Mr. Buffett. So what I think we want to do is see that data, and if you furnish it to us, get it together and furnish it to us, even without a question from us, that would be very helpful.
OtherBe happy to do so, sir.
OtherThank you. All right. Last comment as we wrap up here. As I've read the materials provided by the staff, read innumerable interviews, other background materials. on materials. I'm struck with the fact that with respect to the credit rating agencies, practices, and models, seems to me that the question isn't so much why did this system fail, but why has it lasted so long? And in that vein, I just want to ask you today, what risk do you see from the current credit rating models in the same way you said there are risk for derivatives? Do you see extant risk, current risk, from the model essentially being unchanged from where it was? the mistakes, the disaster, however you characterize it happened?
OtherWell, the huge question, if you were running a rating agency now, if I were running a rating agency now, or if you're on 13% of the stock. How would I rate states and major municipalities? I mean, if the federal government will step in to help them, they're AAA. If the federal government won't step in to help them, who knows what they are.
[2:15:57]
QuestionerAnd I mean, if you're looking now at something where you could look back later on and say, these ratings were crazy. were crazy, that would be the area, because it's, it's, it's, it's, it's, it's, it's, it's, it's, it's, it's bimodal, I mean, basically, uh, and, um, are you satisfied the reason? I don't know how I would rate those myself now. I mean, in other words, it's, because it's a bet on how the federal government will act over time. But the real, well, but also of you, in that vein, have you looked at whether the resources, the discipline, the capacity is there internally at Moody's?
WarrenI don't think, I don't think, I don't think, don't think Moody's or I can come up with any. anything terribly insightful about the question of state and municipal finance five or ten years from now, except for the fact that there will be a terrible problem, and then the question becomes what the federal government? But does the model, irrespective of the particular eminent risk, is the model one that still presents risk, given what you've heard and learned today in looking at Moody's? Well, I think, you're talking about the model and respect. Talk about the model, issuer pays, all the associated issues we've raised with respect. to the Moody's business model? I think there's utility to the rating agencies. I think there's less utility to somebody like me that was in the business of trying to evaluate credits day by day and been doing it a lot of years, but I think there's utility to the model.
QuestionerMr. Chairman, we might as well end on a high note. If we're really looking at the states and municipalities in the comfort that we would get from the federal government proposing to intervene, which then makes the states and the municipalities triple A, There are a lot of folk out there wondering who watches over the watcher in terms of how the federal government is able to do that. Of course, we know they can print their own money and do a few other things, but they've been doing that for some time now. And there is some concern about that as well. I do like to go back to what we talked about in the beginning. Behavior should have consequences that should apply to people, institutions, and governments. Thank you very much, witnesses.
OtherWe are going to take a break member. Take a break members until 2.30, and we will reconvene in this room. Thank you, Mr. Buffett. Thank you, Mr. McDaniel. Thank you.