What Warren thinks...

With Wall Street in chaos, Fortune naturally went to Omaha looking for wisdom. Warren Buffett talks about the economy, the credit crisis, Bear Stearns, and more.

By Nicholas Varchaver,

(Fortune Magazine) -- If Berkshire Hathaway's annual meeting, scheduled for May 3 this year, is known as the Woodstock of Capitalism, then perhaps this is the equivalent of Bob Dylan playing a private show in his own house: Some 15 times a year Berkshire CEO Warren Buffett invites a group of business students for an intensive day of learning. The students tour one or two of the company's businesses and then proceed to Berkshire (BRKA, Fortune 500) headquarters in downtown Omaha, where Buffett opens the floor to two hours of questions and answers. Later everyone repairs to one of his favorite restaurants, where he treats them to lunch and root beer floats. Finally, each student gets the chance to pose for a photo with Buffett.
In early April the megabillionaire hosted 150 students from the University of Pennsylvania's Wharton School (which Buffett attended) and offered Fortune the rare opportunity to sit in as he expounded on everything from the Bear Stearns (BSC, Fortune 500) bailout to the prognosis for the economy to whether he'd rather be CEO of GE (GE, Fortune 500) - or a paperboy. What follows are edited excerpts from his question-and-answer session with the students, his lunchtime chat with the Whartonites over chicken parmigiana at Piccolo Pete's, and an interview with Fortune in his office.

Buffett began by welcoming the students with an array of Coca-Cola products. ("Berkshire owns a little over 8% of Coke, so we get the profit on one out of 12 cans. I don't care whether you drink it, but just open the cans, if you will.") He then plunged into weightier matters:
Before we start in on questions, I would like to tell you about one thing going on recently. It may have some meaning to you if you're still being taught efficient-market theory, which was standard procedure 25 years ago. But we've had a recent illustration of why the theory is misguided. In the past seven or eight or nine weeks, Berkshire has built up a position in auction-rate securities [bonds whose interest rates are periodically reset at auction; for more, see box on page 74] of about $4 billion. And what we have seen there is really quite phenomenal. Every day we get bid lists. The fascinating thing is that on these bid lists, frequently the same credit will appear more than once.

Here's one from yesterday. We bid on this particular issue - this happens to be Citizens Insurance, which is a creature of the state of Florida. It was set up to take care of hurricane insurance, and it's backed by premium taxes, and if they have a big hurricane and the fund becomes inadequate, they raise the premium taxes. There's nothing wrong with the credit. So we bid on three different Citizens securities that day. We got one bid at an 11.33% interest rate. One that we didn't buy went for 9.87%, and one went for 6.0%. It's the same bond, the same time, the same dealer. And a big issue. This is not some little anomaly, as they like to say in academic circles every time they find something that disagrees with their theory.
So wild things happen in the markets. And the markets have not gotten more rational over the years. They've become more followed. But when people panic, when fear takes over, or when greed takes over, people react just as irrationally as they have in the past.

Do you think the U.S. financial markets are losing their competitive edge? And what's the right balance between confidence-inspiring standards and ...
... between regulation and the Wild West? Well, I don't think we're losing our edge. I mean, there are costs to Sarbanes-Oxley, some of which are wasted. But they're not huge relative to the $20 trillion in total market value. I think we've got fabulous capital markets in this country, and they get screwed up often enough to make them even more fabulous. I mean, you don't want a capital market that functions perfectly if you're in my business. People continue to do foolish things no matter what the regulation is, and they always will. There are significant limits to what regulation can accomplish. As a dramatic illustration, take two of the biggest accounting disasters in the past ten years: Freddie Mac and Fannie Mae. We're talking billions and billions of dollars of misstatements at both places.

Now, these are two incredibly important institutions. I mean, they accounted for over 40% of the mortgage flow a few years back. Right now I think they're up to 70%. They're quasi-governmental in nature. So the government set up an organization called OFHEO. I'm not sure what all the letters stand for. [Note to Warren: They stand for Office of Federal Housing Enterprise Oversight.] But if you go to OFHEO's website, you'll find that its purpose was to just watch over these two companies. OFHEO had 200 employees. Their job was simply to look at two companies and say, "Are these guys behaving like they're supposed to?" And of course what happened were two of the greatest accounting misstatements in history while these 200 people had their jobs. It's incredible. I mean, two for two!

It's very, very, very hard to regulate people. If I were appointed a new regulator - if you gave me 100 of the smartest people you can imagine to work for me, and every day I got the positions from the biggest institutions, all their derivative positions, all their stock positions and currency positions, I wouldn't be able to tell you how they were doing. It's very, very hard to regulate when you get into very complex instruments where you've got hundreds of counterparties. The counterparty behavior and risk was a big part of why the Treasury and the Fed felt that they had to move in over a weekend at Bear Stearns. And I think they were right to do it, incidentally. Nobody knew what would be unleashed when you had thousands of counterparties with, I read someplace, contracts with a $14 trillion notional value. Those people would have tried to unwind all those contracts if there had been a bankruptcy. What that would have done to the markets, what that would have done to other counterparties in turn - it gets very, very complicated. So regulating is an important part of the system. The efficacy of it is really tough.

At Piccolo Pete's, where he has dined with everyone from Microsoft's Bill Gates to the New York Yankees' Alex Rodriguez, Buffett sat at a table with 12 Whartonites and bantered over many topics.

How do you feel about the election?
Way before they both filed, I told Hillary that I would support her if she ran, and I told Barack I would support him if he ran. So I am now a political bigamist. But I feel either would be great. And actually, I feel that if a Republican wins, John McCain would be the one I would prefer. I think we've got three unusually good candidates this time.
They're all moderate in their approach.
Well, the one we don't know for sure about is Barack. On the other hand, he has the chance to be the most transformational too.

I know you had a paper route. Was that your first job?
Well, I worked for my grandfather, which was really tough, in the [family] grocery store. But if you gave me the choice of being CEO of General Electric or IBM or General Motors, you name it, or delivering papers, I would deliver papers. I would. I enjoyed doing that. I can think about what I want to think. I don't have to do anything I don't want to do. It might be wonderful to be head of GE, and Jeff Immelt is a friend of mine. And he's a great guy. But think of all the things he has to do whether he wants to do them or not.

How do you get your ideas?
I just read. I read all day. I mean, we put $500 million in PetroChina. All I did was read the annual report. [Editor's note: Berkshire purchased the shares five years ago and sold them in 2007 for $4 billion.]

What advice would you give to someone who is not a professional investor? Where should they put their money?
Well, if they're not going to be an active investor - and very few should try to do that - then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They're not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don't buy all at one time.

When Buffett said he was ready to pose for photographs, all 150 students stampeded out of the room within seconds and formed a massive line. For the next half hour, each one took his or her turn with Buffett, often in hammy poses (wrestling for his wallet was a favorite). Then, as he started to leave, a 77-year-old's version of A Hard Day's Night ensued, with a pack of 30 students trailing him to his gold Cadillac. Once free, he drove this Fortune writer back to his office and continued fielding questions.

How does the current turmoil stack up against past crises?
Well, that's hard to say. Every one has so many variables in it. But there's no question that this time there's extreme leveraging and in some cases the extreme prices of residential housing or buyouts. You've got $20 trillion of residential real estate and you've got $11 trillion of mortgages, and a lot of that does not have a problem, but a lot of it does. In 2006 you had $330 billion of cash taken out in mortgage refinancings in the United States. That's a hell of a lot - I mean, we talk about having $150 billion of stimulus now, but that was $330 billion of stimulus. And that's just from prime mortgages. That's not from subprime mortgages. So leveraging up was one hell of a stimulus for the economy.

If that was one hell of a stimulus, do you think the $150 billion government stimulus plan will make an impact?
Well, it's $150 billion more than we'd have otherwise. But it's not like we haven't had stimulus. And then the simultaneous, more or less, LBO boom, which was called private equity this time. The abuses keep coming back - and the terms got terrible and all that. You've got a banking system that's hung up with lots of that. You've got a mortgage industry that's deleveraging, and it's going to be painful.

The scenario you're describing suggests we're a long way from turning a corner.
I think so. I mean, it seems everybody says it'll be short and shallow, but it looks like it's just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don't invest a dime based on macro forecasts, so I don't think people should sell stocks because of that. I also don't think they should buy stocks because of that.

Your OFHEO example implies you're not too optimistic about regulation.
Finance has gotten so complex, with so much interdependency. I argued with Alan Greenspan some about this at [Washington Post chairman] Don Graham's dinner. He would say that you've spread risk throughout the world by all these instruments, and now you didn't have it all concentrated in your banks. But what you've done is you've interconnected the solvency of institutions to a degree that probably nobody anticipated. And it's very hard to evaluate. If Bear Stearns had not had a derivatives book, my guess is the Fed wouldn't have had to do what it did.

Do you find it striking that banks keep looking into their investments and not knowing what they have?
I read a few prospectuses for residential-mortgage-backed securities - mortgages, thousands of mortgages backing them, and then those all tranched into maybe 30 slices. You create a CDO by taking one of the lower tranches of that one and 50 others like it. Now if you're going to understand that CDO, you've got 50-times-300 pages to read, it's 15,000. If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared, you're now up to 750,000 pages to read to understand one security. I mean, it can't be done. When you start buying tranches of other instruments, nobody knows what the hell they're doing. It's ridiculous. And of course, you took a lower tranche of a mortgage-backed security and did 100 of those and thought you were diversifying risk. Hell, they're all subject to the same thing. I mean, it may be a little different whether they're in California or Nebraska, but the idea that this is uncorrelated risk and therefore you can take the CDO and call the top 50% of it super-senior - it isn't super-senior or anything. It's a bunch of juniors all put together. And the juniors all correlate.

If big financial institutions don't seem to know what's in their portfolios, how will investors ever know when it's safe?
They can't, they can't. They've got to, in effect, try to read the DNA of the people running the companies. But I say that in any large financial organization, the CEO has to be the chief risk officer. I'm the chief risk officer at Berkshire. I think I know my limits in terms of how much I can sort of process. And the worst thing you can have is models and spreadsheets. I mean, at Salomon, they had all these models, and you know, they fell apart.

What should we say to investors now?
The answer is you don't want investors to think that what they read today is important in terms of their investment strategy. Their investment strategy should factor in that (a) if you knew what was going to happen in the economy, you still wouldn't necessarily know what was going to happen in the stock market. And (b) they can't pick stocks that are better than average. Stocks are a good thing to own over time. There's only two things you can do wrong: You can buy the wrong ones, and you can buy or sell them at the wrong time. And the truth is you never need to sell them, basically. But they could buy a cross section of American industry, and if a cross section of American industry doesn't work, certainly trying to pick the little beauties here and there isn't going to work either. Then they just have to worry about getting greedy. You know, I always say you should get greedy when others are fearful and fearful when others are greedy. But that's too much to expect. Of course, you shouldn't get greedy when others get greedy and fearful when others get fearful. At a minimum, try to stay away from that.
By your rule, now seems like a good time to be greedy. People are pretty fearful.

You're right. They are going in that direction. That's why stocks are cheaper. Stocks are a better buy today than they were a year ago. Or three years ago.

But you're still bullish about the U.S. for the long term?
The American economy is going to do fine. But it won't do fine every year and every week and every month. I mean, if you don't believe that, forget about buying stocks anyway. But it stands to reason. I mean, we get more productive every year, you know. It's a positive-sum game, long term. And the only way an investor can get killed is by high fees or by trying to outsmart the market.