2007: How would a credit contraction and higher interest rates affect Berkshire?

AUDIENCE MEMBER: David Winters, Mountain Lakes, New Jersey.

Could you please explain what you believe the impact and, hopefully benefit, of a credit contraction would be on Berkshire Hathaway, and maybe higher interest rates as well?

WARREN BUFFETT: Well, we do benefit when others suffer.

That doesn’t mean we enjoy their suffering, but times of chaos in financial markets, the situation that existed in junk bonds in 2002, the situation that existed in equities, you know, back in 1974.

So I don’t think you’ll necessarily see a contraction in credit. That — I think most authorities are very reluctant to really step on the brakes. You know, it’s too easy to figure out who did step on the brakes.

But you could very well see some exogenous event that starts feeding on itself in markets.

In fact, I think it’s much more prone to feed on itself in markets than in most periods in the past, if you really got a shock to the system.

And that would result in a huge widening of credit spreads, cheaper equity prices, all kinds of things that actually are helpful to Berkshire because we usually have at least some money around to do something at times like that.

There will be periods like that. If you go back 30 or 40 years, when credit contracted, it just really wasn’t available.

Charlie and I went through a couple periods like that. We were trying to buy a bank in Chicago 40 — 40 or so years ago, and the only people that would lend it to us in the world — because banks weren’t lending for acquisitions — we found some people over in Kuwait who said they’d lend it to us in dinars.

And we thought, you know, it might be fine to borrow it, but when it came time to pay them back the dinars, they would probably be telling us what the dinar was worth, so we passed on that particular deal.

But you had real credit contractions then. And, of course, the whole reason — not — I would say the major reason the Federal Reserve was established was the huge contractions in credit that were felt, particularly here in places like the Midwest where they were dependent on correspondent banks in the larger cities, and when those banks had problems, the banks here got shut off.

And we really needed a system that would not have that happen except by design. And I would say the Fed, by design, is probably not going to produce any credit crunches.

Charlie?

CHARLIE MUNGER: Well, the last time we had that credit contraction, we made, what, a quick 3 or $4 billion? And we were acting with vigor.

The whole investment world is more and more competitive, and if you talk about a real credit contraction, which gums up the whole civilization, no one would welcome that.

And I would predict that if we ever had a really big credit contraction after a period like the one we’re in with all this excess, which is causing so much envy and resentment, that we would get legislation that most of us wouldn’t like.

WARREN BUFFETT: There’s a book by Jonathan Alter that came out about a year ago that talks about the first hundred days after [President Franklin] Roosevelt took over [in 1933], and by the nature of the book it tells about some of the days before that, too.

But if you want to get an example of — I mean, this country was close to the brink at that point, and, basically, Roosevelt got anything passed he wanted, just as fast as they could write the bills there, initially. And that was a good thing, you know, with banks closing and people dealing in scrip and that sort of thing.

So nobody wants that to come back, and we’ve learned a lot more about that sort of thing since the Great Depression.

I don’t think you’ll see an orchestrated credit contraction.

Now, you had in 1998, in the fall, when Long-Term Capital Management got in trouble, you had a seize up of the credit markets.

It wasn’t an orchestrated by the Fed-type contraction. You simply had people panicked about even the most — even the safest of instruments and credit spreads doing things that they’d never done before.

And that’s rather an interesting example, because that was not a hundred years ago. It was less than ten years ago. You had all kinds of people with high IQs in Wall Street. You had all kinds of people with cash available.

And you had some really extraordinary things happen in credit markets simply because people panicked and they felt other people were going to panic. And you get these second- and third-degree type reactions in markets.

We will see that sort of thing again. It won’t be the same but, you know, as Mark Twain said, history doesn’t repeat itself but it rhymes. And we will have something that rhymes with 1998.