Commentary by Alice Schroder
April 19 (Bloomberg) -- At the height of the financial crisis, Goldman Sachs sold Warren Buffett’s Berkshire Hathaway $5 billion of perpetual preferred stock with a 10 percent dividend and warrants on $5 billion worth of common stock at a strike price of $115 a share.
This package gave Berkshire a return of more than 15 percent in exchange for its money and Buffett’s endorsement, which Goldman desperately needed to raise funds to survive the panic.
At first it seemed that Berkshire had gotten a rich price for Buffett’s one-time imprimatur to help Goldman avert failure in a liquidity crunch. Since then, Buffett has been sitting in Omaha, Nebraska, cashing checks for $500 million a year. The preferred is an extremely expensive form of capital that is redeemable at Goldman’s option. It is costing Goldman $100 million to $200 million a year in extra dividends compared with the cost if it refinanced. Goldman can afford it, so why has it not paid this money back?
Meanwhile, instead of regaining its luster since the financial crisis, Goldman has produced a nonstop soap opera of indignities unbefitting a blue-chip bank. Keeping the preferred makes no sense -- unless Goldman values having Buffett’s reputation on call even more, as insurance.
Deals like the preferred-stock investment do present moral hazard. The parties’ interests aren’t only opposed, but Goldman knows far more about its internal problems and risks than Buffett, and has more control over the course of events. Buffett had already been spattered with his share of mud associated with Goldman even before the Securities and Exchange Commission filed civil fraud accusations against it last week for allegedly creating and marketing a collateralized debt obligation that was designed to lose money. (The bank calls the allegations “completely unfounded.”)
Last week, one of Berkshire’s directors, Ron Olson, speaking on Bloomberg Television ahead of Berkshire’s annual meeting, defended Goldman, saying that Buffett invested out of belief in “not just the strength of Goldman but its integrity.” With horrible timing for Buffett, the SEC filed its suit three days later.
Goldman had gotten a Wells notice in July 2009 informing it that the SEC might file civil fraud accusations. It didn’t disclose that to investors. While this disclosure isn’t required, most companies do it. You have to wonder whether Buffett knew.
What else might Goldman Chief Executive Officer Lloyd Blankfein have not told Buffett while Buffett was defending Blankfein as the best person to run the bank? When Buffett struck the deal with Goldman he had never met Blankfein. Some thought Buffett was really investing in his trusted Goldman banker, Byron Trott, who was sometimes mentioned as a possible successor to Blankfein. But Trott left Goldman six months after Buffett made the investment to start his own private-equity fund.
Buffett made a similar deal once before when he invested $700 million of Berkshire’s money in Salomon Brothers in the 1980s on little but faith in its management. The parallels between the two investments are striking enough that it raises the question: What could Buffett have been thinking by investing in Goldman? He was again buying into a business that he once professed to despise. He was again renting out his reputation in a way that subjected him to moral hazard.
Salomon had covered up employee misconduct, held back information from its directors, including Buffett, and almost went bankrupt after defrauding the government in Treasury bond auctions.
The Salomon experience, though, may shed some light on why Buffett did it, because it taught him a lesson: that renting his reputation could actually enhance it if the disgraced company recovers. Buffett told Congress he would be ruthless with anyone who lost “a shred of reputation” for Salomon. It survived, and Buffett was credited as the hero.
It seemed then as if he could cure a company’s ills simply by associating with it. And so, when Buffett says he invested in Goldman Sachs because of its management’s “integrity,” he may really be saying that Goldman must have integrity because he invested in it.
This, I believe, is where Buffett miscalculated. Years ago he became too much of a corporate insider to be truly independent, but for a long time it didn’t seem to matter. This latest metamorphosis is embarrassing. The commercial nature of the transaction is so transparent that it can’t be disguised with talk of integrity.
Buffett swapped his reputation at a cheap price. Goldman is holding him to the deal, hanging onto the preferred stock while Buffett’s reputation is still useful. It is painful to watch Buffett behaving like a hostage to Wall Street, damaging himself by defending investment banks and saying flattering things about Goldman in a way that contradicts any principled view of the securities business.
When Goldman’s fortunes eventually reverse, it won’t change anything. Goldman will doubtless be perceived as the blue chip of Wall Street again.
The list of problems that occurred after the 2008 financial crisis are nonetheless indelible and will stand alongside the firm’s marketing of closed-end investment trusts before the stock market crash of 1929 as one of the two great black marks in the firm’s history. Berkshire will exercise its warrants, and will pocket its financial gains, which are the price of being associated with Goldman in this episode. The money wasn’t enough. Goldman outsmarted Buffett in this deal.Share Investor LinksDownload the 2009 Warren Buffett Letter & 2009 Annual Report to Berkshire Hathaway Shareholders
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