Smart people still argue what caused the Great Depression, almost nine decades after it happened. That’s the nature of deep recessions. The desire to assign blame to tragedy — and the will to avoid being blamed — makes these debates less scientific than we’d like.
One way to make sense of what happened is piecing together stories from those involved. The government tried this six years ago when it set up the Financial Crisis Inquiry Committee, interviewing dozens of bankers, regulators, top investors and politicians to try to figure out what happened.
One person the committee questioned was Warren Buffett. The interview took place in 2010, but the transcript wasn’t public until last week.
You can read the whole thing here. It’s 103 pages and totally fascinating.
I pulled out a few of my favorite parts. The quotes are lightly edited for clarity.
On what caused the housing bubble:
“The basic cause, you know, embedded in psychology, was a pervasive belief that house prices couldn’t go down and everyone, virtually everybody, succumbed to that. But that’s the only way you get a bubble is when basically a very high percentage of the population buys into some originally sound premise. It’s quite interesting how that develops.
The originally sound premise that becomes distorted as time passes and people forget the original sound premise and start focusing solely on the price action. So the media investors, the mortgage bankers, the American public, me, my neighbor, rating agencies, Congress, you name it — people overwhelmingly came to believe that house prices could not fall significantly. And since it was biggest asset class in the country and it was the easiest class to borrow against, it created probably the biggest bubble in our history.”
On the nature of bubbles:
“My former boss, Ben Graham, made an observation, 50 or so years ago to me that it really stuck in my mind and now I’ve seen evidence of it. He said, “You can get in a whole lot more trouble in investing with a sound premise than with a false premise.”
If you have some premise that the moon is made of green cheese or something, it’s ridiculous on its face. If you come out with a premise that stocks have historically done better than bonds [and history shows that’s the case, people put their money behind it.]
That became the underlying bulwark for the 1929 stock bubble. People thought stocks were starting to be wonderful and they forgot the limitations of the original premise. So after a while, the original premise, which becomes sort of the impetus for what later turns out to be a bubble, is forgotten and the price action [prices going up] takes over.
We saw the same thing in housing. It’s a totally sound premise that houses will become worth more over time because the dollar becomes worth less. It isn’t because construction costs go up. It isn’t because houses are so wonderful. It’s because the dollar becomes worth less, and that a house that was bought 40 years ago is worth more today than it was then.
And since 66 or 67 percent of the people want to own their own home, and because you can borrow money on it and you’re dreaming of buying a home, if you really believe that houses are going to go up in value, you buy one as soon as you can. And that’s a very sound premise. And once that gathers momentum and it gets reinforced by price action and the original premise is forgotten, which it was in 1929.
The Internet was the same thing. The Internet was going to change our lives. But it didn’t mean that every company was worth $50 billion that could [go public].
And the price action becomes so important to people that it takes over their minds. Because housing was the largest single asset, around $22 trillion or something like that. Such a huge asset. So the public — they might not understand stocks, they might not understand tulip bulbs, but they understood houses. And the [easy] financing, you could leverage up to the sky, it created a bubble like we’ve never seen. I wish I had figured that out in 2005.”
On debt and risk:
“It gets down to leverage overall. I mean, if you don’t have leverage, you don’t get in trouble. That’s the only way a smart person can go broke, basically. I’ve always said, “If you’re smart, you don’t need it; and if you’re dumb, you shouldn’t be using it.”
On the psychology of bull markets:
“When your neighbor has made a lot of money by buying Internet stocks, and your wife says, “You’re smarter than he is and he’s richer than you are, so why aren’t you doing it?” …
People don’t have to be trained to want to gamble in this country, but they have this instinct — a great many people — they’re encouraged when they see some successes around. That’s why the bells and whistles go off in the casino when somebody hits a jackpot, you know.”
On companies promising results:
“Any time a large financial institution starts promising regular earnings increases, you’re going to have trouble, you know? … If people are thinking that way, they are going to do things, maybe in accounting, that I would regard as unsound.”
On the difference between investing, speculating, and gambling:
“It’s a tricky definition. It’s like pornography, and that famous quote on that.
I look at it in terms of the intent of the person engaging in the transaction. An investment operation in my view is one where you look to the asset itself to determine your decision to lay out some money now to get some more money back later on. So you look to the apartment house, you look to the stock, you look to the farm, in terms of what that will produce. You don’t really care whether there is a [price] quote on it at all. You are basically committing some funds now to get more funds later on, through the operation of the asset.
Speculation, I would define as much more focused on the price action of the stock. You think quarterly earnings are going to be up or the stock is going to split, or whatever it may be, or increase the dividend — but you are not looking to the asset itself.
The real test of what you’re doing is whether you care whether the markets are open. When I buy a stock, I don’t care if they close the stock market tomorrow for a couple of years because I’m looking to the business to produce returns for me in the future from the business.
Now, if I care if whether the stock market is open tomorrow, then to some extent I’m speculating because I’m thinking about whether the price is going to go up tomorrow or not. I don’t know whether the price is going to go up.
Gambling, I would define as engaging in a transaction which doesn’t need to be part of the system. I mean, if I want to bet on a football game, you know, the football’s game’s operation is not dependent on whether I bet or not.”
On calling the top of a market bubble:
“If you were a Cassandra in 2005 or 2006, and houses kept going up, after a while people quit listening. And incidentally a lot of the Cassandras are nuts, anyway. So you have a fringe element to Cassandras, too.”
On regulations preventing bubbles:
“If Freddie and Fannie had said, “We will only accept mortgages with 30 percent down payments, verified income, and the payments can’t be more than 30 percent of your income,” you know, that would have stopped [the housing bubble]. But who can do that? In fact, I think if you recommend that as a course of a future mortgage action, you better get an unlisted phone number.”
On high CEO compensation:
“Well, it’s perfectly understandable. You’ve got a CEO that cares enormously about his compensation. You’ve got a compensation committee that meets for a few hours, maybe, every meeting. You’ve got an HR vice president who is working for the CEO that probably suggests a compensation consultant — a compensation consultant who is draconian is not going to get hired. And then you’ve got this comparison factor, and [boards of directors] say, “We didn’t hire a guy on the bottom quartile to be our CEO so we’re not going compare to the bottom quartile and we’re not going to compare to the next-to-the-bottom quartile.” So it just ratchets up.”
On fraud leading up to the crisis:
“Well there was, obviously, a lot of fraud. There was fraud on the parts of the borrowers and there was frauds on the part of the intermediaries, in some cases. But you’d better not have a system that is dependent on the absence of fraud. It will be with us.”
On the future:
“We will have other bubbles in the future. I mean, there’s no question about it.”