Warren Buffett or the Oracle of Omaha is well known for his conservative views on finance.
He likes companies that are easy to understand and dislikes leverage or opaque financial structures and instruments, such as derivatives. His conglomerate, Berkshire Hathaway has rarely used excessive leverage or derivatives, and as long as Warren Buffett is in charge, it will remain that way.
Unfortunately, the rest of Wall Street does not hold similar views. If it did, the world would be a much safer place to invest.
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You could argue that one of the reasons why Buffett has been so successful over the past six decades is for this reason. He’s avoided borrowing substantially and has, therefore, been able to buy when others are being forced to sell thanks to their excessive borrowing.
The critical problem with taking on debt, for both companies and individuals, is that it severely limits your options. You will do everything in your power to pay back your creditors, but the world is unpredictable, and when the unexpected happens, if you have no room for maneuver, there’s no way out.
Warren Buffett explained this (with a much more visual analogy) to MBA students and undergraduate students at the Notre Dame Faculty as part of a series of lectures he gave in the spring of 1991:
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“The question is whether LBOs and junk bonds and so on have hurt the country in some fundamental way in terms of its competitiveness vis-à-vis the world. I wouldn’t go that far, but I think on balance it’s been a huge minus on the financial scene. Extreme leverage has been, generally speaking, a net minus. The analogy has been made (and there’s just enough truth to it to get you in trouble) that in buying some company with enormous amounts of debt, that it’s somewhat like driving a car down the road and placing a dagger on the steering wheel pointed at your heart. If you do that, you will be a better driver – that I can assure you. You will drive with unusual care. You also, someday, will hit a small pothole, or a piece of ice, and you will end up gasping. You will have fewer accidents, but when they come along, they’ll be fatal. Essentially, that’s what some of corporate America did in the last 10 years. And it was motivated by huge fees. And it was motivated by greed.”
He went on to detail one of the most disastrous cases of excessive borrowing that he has ever seen:
“The most extreme case I saw was a television station. About three years ago, a television station in Tampa sold for an amount where, when they had to borrow the money, the interest amounted to more than the total sales of the station. If everybody donated their labor, if they donated their programming, if they donated their utilities, they still wouldn’t have enough to pay the interest. They went crazy. And you can buy those bonds at 15 cents on the dollar. Charlie Keating’s enterprise [Lincoln Savings and Loan Association in California, which became the nation’s largest thrift failure] had a bunch of them too. There’s a lot of crazy stuff that went on in the last five or six years. The fees on that deal, they paid $365 million for the station, they borrowed $385 million and you can guess where the extra money went. It went into the pockets of the people who put the deal together.”
Buffett then moves on to talk about the problems one particular real estate mogul was facing at the time.
In 1990, Donald Trump had fallen off the Forbes 400 rich list, and despite his insistence to the contrary, his real estate empire was in decline.
In 1991, the Trump Taj Mahal Casino Resort in Atlantic City filed for bankruptcy, and then, in 1992, the historic Plaza Hotel in New York, once called a “Mona Lisa” by Trump, collapsed. Despite these problems, Trump was still claiming that he was worth $3.7 billion at during the year.
According to Buffett, Trump’s biggest problem was debt; he had taken on too much. But due to the fact Trump owed billions, not millions, creditors were more than willing to give him extra breathing space and allow the borrowing to continue. As Buffett describes:
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“Where did Donald Trump go wrong? The big problem with Donald Trump was he never went right. He basically overpaid for properties, but he got people to lend him the money. He was terrific at borrowing money. If you look at his assets, and what he paid for them, and what he borrowed to get them, there was never any real equity there. He owes, perhaps, $3.5 billion now, and, if you had to pick a figure as to the value of the assets, it might be more like $2.5 billion. He’s a billion in the hole, which is a lot better than being $100 in the hole because if you’re $100 in the hole, they come and take the TV set. If you’re a billion in the hole, they say ‘hang in there Donald.'”
Buffett concludes his speech on the topic of leverage by saying that it’s “interesting” when smart people like Trump end up blowing themselves up.
He says “I’ve seen all sorts of people with terrific IQ’s that end up flopping in Wall Street” because they “beat themselves.” They either end up going too fast, not making the most out of each opportunity they have available to them or “they have their foot on the brake and the accelerator at the same time.”
