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02.12.09

Buffett's Risky Business

Yesterday, Warren Buffett reported that last year was Berkshire Hathaway's worst year on record. Earlier this month, Edward Jay Epstein reported that the Oracle of Omaha made a huge profit investing in Moody's, a firm that gave toxic assets the holy triple-A rating.

Will anyone escape unscathed by responsibility from the great financial crisis? Not, it would appear, Warren Buffett, the revered Oracle of Omaha. One of the faulty pillars that brought the whole house crashing down was the super-safe, triple-A investment ratings awarded to what we now know were "toxic assets." Buffett is a major stockholder in one of the firms that awarded these grades in a reckless and greedy race to the bottom

By 2008, while there were still only 12 triple-A-rated corporations in the world, there were more than 64,000 triple-A-rated debt packages with a face value of some $3 trillion, spreading like kudzu through the global banking system.

After Moody's Corp. went public in 2000, Warren Buffett’s holding company, Berkshire Hathaway, invested just under $500 million, making it by far Moody's largest shareholder. At the time, Moody’s was a stodgy bond-rating company that, together with Standard & Poor’s and Fitch, enjoyed what amounted to a government-backed monopoly on issuing investment ratings.

The most coveted grade is triple-A, which implies a very low risk of default and allows corporations to sell these bonds to insurance companies, pension funds, and other institutions that are restricted by law to the safest investments. The ratings firms play a double role, both evaluating the risk of a company’s debt and—for additional fees—offering consulting services to help a company raise its score to triple-A.

But since there were no more than a dozen companies in the entire world eligible for a triple-A rating in 2001, the money Moody's could make from these two services was limited. The way around this barrier was the much more profitable business line of helping companies earn triple-A ratings for a new kind of financial instrument: "structured debt."

The "structuring" part involved some financial alchemy by which pools of debt, including subprime mortgages and credit-card debt, were combined with a derivative called a credit default swap (to insure them, in theory at least, against default), and sliced into "tiers" according to their relative risk.

To sell these to institutional investors, however, needed one further piece of magic: a good rating. And to obtain the triple-A’s crucial seal of approval, the underwriters of these new, more complex instruments were willing to pay the rating services triple what they charged for grading and consulting on corporate debt. Compounding this bonanza, they paid the same handsome fees for rating the aptly named "piggy back" packages, in which the original structured-debt package served as 100 percent collateral.

Rushing to mine this El Dorado, Moody's, as well as Standard & Poor, assigned triple-A grades to nearly 75 percent of the so-called collateralized debt it rated, most of which included subprime mortgages. By 2008, while there were still only 12 triple-A-rated corporations in the world, there were more than 64,000 triple-A-rated debt packages with a face value of some $3 trillion, spreading like kudzu through the global banking system.

By 2007, Moody's alone had taken in more than $3 billion in fees, and its share price had skyrocketed to a point where Buffett's stake was valued at $3.2 billion, giving him a paper profit of $2.7 billion.

Buffett is not only one of the savviest investors in the annals of capitalism; he is also one who prides himself on scrutinizing his major investments. So he must have been aware that Moody's immense profit was based on the proliferation of derivative-backed debt. He is also well-acquainted with credit default swaps—which were the window dressing used to justify triple-A ratings—because Berkshire Hathaway is one of the major sellers of them.

Finally, Buffett was well aware of the dangers of derivative contracts, describing them in his company's 2002 annual report as "time bombs, both for the parties that deal in them and the economic system."

When these bombs exploded in 2008, Moody's quickly downgraded about 90 percent of all the structured debt it had given its seal of approval in the previous two years. It is now being scrutinized by Connecticut Attorney General Richard Blumenthal for ''potential fraud'' in connection with a possible ''coverup'' of inaccurate ratings (and, according to a Moody's spokesman, is fully cooperating with the investigation). A spokesman for Warren Buffett said that "Mr. Buffett does not discuss the holdings of Berkshire Hathaway."

As it turns out, the Oracle of Omaha was right when he predicted in 2002 that derivatives would be "financial weapons of mass destruction." Alas, the Oracle's words did not match his deed when there was a multi-billion-dollar profit to be made.

Edward Jay Epstein studied government at Cornell and Harvard, and received a Ph.D from Harvard in 1973. His master's thesis on the search for political truth (Inquest: The Warren Commission and the Establishment of Truth) was later published as a book. The Big Picture: The New Logic of Money and Power in Hollywood is his thirteenth book. The sequel, The Hollywood Economist will be published in January 2010.