Over the past month, the collapse of Silicon Valley Bank (SVB), Signature Bank, Silvergate, and Credit Suisse have shaken the foundations of the global financial system.
Despite significant changes in the regulatory landscape since 2008 and the many talking heads that have promised that financial crises are a thing of the past, the sudden collapse of several major institutions over a few short days certainly makes a loud statement.
And – With a number of other mid-sized banks (like First Republic) still under some pressure, many people are worried.
Moments like these certainly prove why the economist Hyman Minsky’s quote, “Stability breeds instability”, may be timeless. Perhaps no amount of regulation can remove instability because human nature demands it.
Moments like these should also remind us why Buffett / Berkshire continues to stand alone as the greatest investor of modern times. Many people and companies fly high for a while, but very few have lasted through decades of different business and investment cycles.
Buffett often reminds investors of the dangers of leverage.
As Buffett says in his characteristic tongue-in-cheek way:
My partner Charlie says there is only three ways a smart person can go broke: Liquor, ladies and leverage. Now the truth is – the first two he just added because they started with L – it’s leverage.
Source: CNBC
However, Buffett didn’t do it without leverage.
What’s remarkable is that he figured out ways to employ leverage while minimizing risks.
Back in 2017, Capital Flywheels noted that this was likely one of Buffett’s greatest and most overlooked edge:
Seems to me the key for Buffett has been taking on leverage while avoiding the downside of leverage. And Berkshire’s insurance core has been the perfect structure to mitigate leverage risks.
There are 2 major problems with traditional leverage: 1) Capital calls at an inopportune time, and 2) Magnification of losses forcing investors to exit positions prematurely.
At Berkshire, float is generated through insurance and reinsurance premiums tied to autos and, generally, “catastrophes”. It’s clear that leverage generated through these avenues are likely to exhibit lower correlation to the general business cycle. People are generally more reluctant to default on autos than on homes, and the timing of major natural disasters are independent of recessions. Not only do these qualities limit the potential of inopportune capital calls, it likely ensures the availability of capital at an opportune time – the bottom of a cycle / recession.
One can argue that the risk of leverage has not been eliminated, merely offset from the business cycle. After all, he will eventually need to pay out claims. Although this is true, Berkshire’s insurance businesses not only earn underwriting profits, they also generate more float/premiums than they pay out in claims in a majority of years (i.e. cost-free float and negative working capital). With growing float/premiums, losses can be backed with future premiums. The value of this advantage cannot be understated – imagine what you could do with leverage if you knew that it would never have to be paid back or know with high assurance that you can pay it back with future cashflows. This increases what looks like limited duration capital (say 3-5 years for auto float) to far-longer (dare I say permanent?) duration capital.
Source: Berkshire’s Performance Edge that No One Talks About
Berkshire, not unlike (Silicon Valley) Bank(s), borrows money from people in order to invest.
Berkshire, not unlike (Silicon Valley) Bank(s), needs to eventually return that money to its lenders.
What is different is that depositors can demand their money back at any time, while insurance buyers can only demand their money if they crash their car (and only if not on purpose) or suffer a catastrophe.
Imagine how differently the situations would have worked out for the banks if VCs and the Twitterati couldn’t just incite deposit flight at any time they’d like.
Buffett’s edge indeed.