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The Science of Hitting
The Science of Hitting
Articles (563) 

Buffett's Decision to Sell Freddie Mac

'Financial institutions tend to make us nervous when they’re trying to do well'

September 04, 2019 | About:

I recently recorded a podcast with Trey Henninger of DIY Investing. During our discussion, he asked for my thoughts on finding high-quality managers to partner with for the long-term. In response, I discussed something Warren Buffett (Trades, Portfolio) once said that has stuck with me:

“You know, there is seldom just one cockroach in the kitchen. You turn on the light and, all of a sudden, they all start scurrying around. And I couldn’t find the light switch, but I had seen one.”

That quote is from Buffett’s May 2010 interview with the Federal Crisis Inquiry Commission. He said it in response to a question about Fannie Mae and Freddie Mac. For background, Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) made “major purchases” of Freddie Mac in the late 1980s. In the late 1990s, the position was worth a few billion dollars. But in 2000, Buffett and Charlie Munger (Trades, Portfolio) decided to sell nearly all of their position. At the 2001 shareholder meeting, they discussed why they made that decision:

"Buffett: There were certain aspects of the business that we felt less comfortable with as they unfolded. And the consequences of what we saw may not hurt the companies at all. But they made us less comfortable than we were earlier, when those practices or activities didn’t exist. I would stress we did not sell because we were worried about more government regulation of Freddie and Fannie. If anything, just the opposite. Wall Street occasionally will react negatively to the prospect of more government regulation and the stocks will react sometimes short-term for that reason. But that was not our reason. We felt the risk profile had changed somewhat.

"Munger: Yeah, but that may be a peculiarity of ours. We are especially prone to get uncomfortable around financial institutions.

"Buffett: We’re quite sensitive to risk in banks, insurance companies or in what they call GSE’s here, in the case of Freddie and Fannie. We feel there’s so much about a financial institution that you don’t know by looking at just figures, that if anything bothers us a little bit, we’re never sure whether it’s an iceberg situation or not… We have seen enough of what happens with financial institutions that push one way or another, that if we get some feeling that that’s going on, we just figure we’ll never see it until it’s too late anyway. So, we bid adieu and wish them the best without any implication that they’re doing anything wrong. It’s just that we can’t be 100% sure of the fact they’re doing things that we like. And when we get to that situation, it’s different than buying into a company with a product or something, or a retail operation. You could spot troubles usually fairly early in those businesses. You spot troubles in financial institutions late. It’s just the nature of the beast.

"Munger: Financial institutions tend to make us nervous when they’re trying to do well. That sounds paradoxical, but that’s the way it is."

During the 2010 interview with the FCIC, Buffett explained his decision in more detail:

“I was concerned about the management at both Freddie and Fannie, although our holdings were concentrated in Freddie. They were trying to and proclaiming that they could increase earnings per share in some low double digit range or something of the sort. And any time a large financial institution starts promising regular earnings increases you’re going to have trouble. It isn’t given to man to be able to run a financial institution where different interest rates scenarios will prevail and all of that comes to produce smooth regular earnings from a very large base to start with. So, if people are thinking that way, they’re going to do things, maybe in accounting but also in operations, that I would regard as unsound. I don’t know when it’ll happen, I don’t even know for sure if it’ll happen. It will happen eventually if they keep up that policy, so I just decided to get out. As I remember it was Philip Morris bonds … they’d made a large investment in that. Now, they’re dealing essentially with government guaranteed credit. We knew that then; we’ve had it ratified subsequently. So, here was an institution that was trying to serve two masters, Wall Street and her investors, and Congress. And they were using this power to do something that was totally unrelated to the mission and then they gave me some half-baked explanation about how it increased liquidity which was just nonsense. And the truth was they were arbitraging the government’s credit. And for something the government really didn’t intend for them to do.”

Let’s walk through the chain of events. Berkshire was a meaningful investor in Freddie for well over a decade, with a position worth billions of dollars (at year-end 1998, Freddie accounted for more than 10% of Berkshire’s common stock portfolio). Clearly, they viewed this as a high-quality business with sustainable competitive advantages; as Buffett noted at the 1993 meeting, “They essentially have economics that other people can’t touch for intermediating money.” Finally, as he said in 2001, what they spotted “may not hurt [Freddie] at all.” But apparently all of this wasn’t good enough: When the gurus saw management doing something that raised their eyebrows, they didn’t dither. They swiftly made their way out the door.

Given that set of facts, I think their decision to completely exit such a meaningful position is pretty profound. In a similar situation, I could see myself finding excuses for hanging around. I think there’s an important lesson here for fellow investors to learn from Warren and Charlie's behavior.

Disclosure: Long Berkshire Hathaway.

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

bgeo
Bgeo - 2 weeks ago    Report SPAM
I watched several hours of the Financial Crisis Inquiry Commission hearings and I copied some of the more interesting testimony. One of the videos I copied then posted to YouTube was Warren Buffett (Trades, Portfolio) responses to Peter Wallison's questions about the bubble and the crisis. Mr. Buffett's comments on the reasons for his sale of Freddie Mac's stock are in the video, begginning at about 3:30 on the progress bar, at: [youtu.be]
The Science of Hitting
The Science of Hitting - 2 weeks ago    Report SPAM

Awesome, thanks for sharing Bgeo!

Praveen Chawla
Praveen Chawla premium member - 1 week ago

Very nice. In hindsight GE had the same problem - it became a financial institution disguised as a industrial under Jack Welch.

The Science of Hitting
The Science of Hitting - 1 week ago    Report SPAM

That's a good point Praveen. GE's obsessive focus with delivering short-term results (and morphing into a financial institution) fits well with that Munger quote above. Thanks for the comment!

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