In 2003, Warren Buffett acquired Clayton, a family-run business based in Maryville, Tenn. In a memo, obtained by Fortune, to Berkshire Hathaway's (BRKB) board of directors, Buffett pointed out how well Clayton's loan portfolio has held up, even though 45% of the company's loans are to borrowers with subprime credit scores.
The company's loan delinquency rates have been stable: On June 30, 2004, the rate was 3.26%; last year it was at 3.5%; and now it's 3.82%. (In comparison, the delinquency rate in the traditional housing market is around 6.4%.) Annual credit losses are running steady at a reasonable 1.5% of the loan portfolio. And Clayton's foreclosures have actually dropped from two years ago, from 5,823 to 4,588.
What's behind the portfolio's strength? Clayton is more careful about lending because it keeps all loans on its own books rather than offloading them to others by means of securitization.
As Buffett wrote, "When we make a mistake in making or buying a loan, it costs us money, not some buyer thousands of miles away who ends up with an RMBS, CDO, or (horror of horrors) a CDO squared."
Another important fact is that Clayton has banked on homebuyers who can afford their monthly payments and who purchased their houses for shelter, not for speculation. Clayton also avoided the mortgage industry practice of enticing buyers with low initial payments, followed by much higher payments a few years down the road. Most notably, Clayton's customers aren't likely to walk away from a house simply because it has lost value.
"If people purchased a house with the idea that it would appreciate substantially in the next few years, they may elect not to make their payment," Buffett wrote. "Since our borrowers did not come in with those expectations, they will quit making payments only when they can't make the payment."Share Investor Blog - Stockmarket & Business commentary
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