B000U5KFIC EBOK (31 page)

If you mix raisins with turds, they are still turds.

Charlie Munger, Berkshire Hathaway annual meeting, May 2000

ESCo FINANCIAL, ONCE SIMPLY THE parent company of a small
Pasadena-based savings and loan institution with the plain-wrap
name of Mutual Savings, was a source of contention for Charlie Munger
and Warren Buffett almost from the moment they bought it. Over time
however, Wesco Financial, like its majority owner Berkshire Hathaway,
was transformed into an entirely different business from what it was
originally. Berkshire is the big canvas on which Buffett-with the help
of Munger-paints his large masterpiece. Wesco is a smaller work on
which Munger-with the help of Buffett-has made his own colorful
imprint.

Shortly after Blue Chip Stamps bought a modest number of shares in
Wesco in 1974, Buffett and Munger waged a battle to stave off an unacceptable acquisition by another California thrift. That was followed by a
Securities and Exchange Commission investigation into the way Buffett,
Munger, and others were structuring business deals (see Chapter Ten).
The SEC investigation was a hassle, but in the end, Berkshire Hathaway
was transformed into a holding company of some substance, and that
was good.

Then, following a deep rift between Munger, powerful members
of a savings and loan trade organization and federal regulators, Wesco was completely remade into a holding company similar in structure to
Berkshire.

Since 1976, Wesco and its owner Blue Chip Stamps, have been buried
within the structure of Berkshire. Nevertheless, said Buffett, "Blue Chip
Stamps still owns our Wesco stock. Because it came that way. We now
have what we owned in the 1970s, 80.1 percent."

By following the ownership thread, it is clear that since Berkshire
owns 100 percent of Blue Chip and because Buffett is Berkshire's largest
shareholder, owning more than 35 percent, he controls Wesco. Yet, as is
the case with the other Berkshire companies, Buffett does not participate
directly in the management of Blue Chip or of Wesco, though he serves as
a director of Wesco-Financial Insurance Company (Wes-FIC) and Precision Steel Warehouse, wholly-owned subsidiaries of Wesco.

It is Munger who is Wesco's chairman. He lives in the same area
where the company is headquartered and even more important, he is well
liked by Betty Peters, whose family founded the company. The Peters family still own about 1.3 percent of Wesco's outstanding stock.

The chairman's job pays Munger nothing, though he does earn
$100,000 per year as vice chairman of Berkshire Hathaway and chairman
of Blue Chip Stamps. In addition, Charlie now collects director's fees
from Costco Wholesale Corporation. He once earned director's fees from
Salomon Inc. and U.S. Airways Group, companies in which Berkshire
Hathaway held large equity positions.'

In recent years, Wesco's annual meeting has become a royal court
where Charlie holds forth on his own, beyond the wide and bright circle
of light cast by Buffett at the Berkshire shareholders' event. For a long
time, Wesco held its annual meeting in a tired, 1950s-style cafeteria at
the seedier end of Pasadena's glamorous Colorado Boulevard. Each year
the crowd at the meeting got larger and each year the long, narrow banquet room, with its fading floral wallpaper and dingy carpet, seemed
more cramped.

The 1997 Wesco meeting, which takes place in May about two weeks
after Berkshire Hathaway's, was attended by 100 or so people. "Typical
group of gluttons (for punishment) and masochists-when you attract
that crowd it gets bigger every year because nobody ever leaves," grumbled Munger.

Charlie was correct. In 1997, the cafeteria went out of business and
Wesco's 1998 meeting was moved. The room at Pasadena's McCormick &
Schmick's seafood restaurant was again too small to hold the crowd. In
1998, the crowd more than doubled and in 1999, 500 to 600 people attended the gathering. There are many faithful: Individual investors like
Mr. and Mrs. Anwar, from Virginia; the Kilpatricks from Alabama; Jolene Crowley from El Cajon, California, and others who return again and
again. Many analysts, investment advisors, and institutional investors also
show up.

"I want to apologize for the elaborateness of this room," Munger told
the shareholders at McCormick & Schmick's. "Many of you have come to
our annual meeting when we held it in the cafeteria in the basement of
the old Mutual Savings Building. And then we moved it to a rather modest
room in a building we own which was leased to a cafeteria. But they gave
up the ghost-and that building is now vacant."

Munger explained that it would have cost more to clean the building
up and move furniture into the vacant restaurant than it cost to rent a
room fora few hours.

"But I know that many of you are disappointed to see our annual
meeting held in such an elaborate room-even if your heavy attendance
has established a new record for occupancy per square foot," lie joked.

Charlie clearly is the star of the Wesco show, and at the 1999 meeting
shareholders stayed in their chairs for three hours plying the 75-year-old
capitalist with questions. But Munger didn't become a sensation overnight. He began to catch the attention of the business world-along with
Berkshire and Wesco shareholders-in the 1980s.

While Warren wrote the famous chairman's message for the Berkshire Hathaway annual report, Charlie wrote Wesco's message. Wesco's
report was published independently, then parts of it were reprinted in
the back of the Berkshire document. Munger used the early chairman's
letter to do two things. First, he described the evolution of Wesco after it
was merged into Berkshire. At the same time, he began warning shareholders, and indeed any one else who was willing to listen, of an
approaching tempest in the savings and loan industry. With the backing
of Buffett, he eventually made it hold public statement that got the thrift
industry's attention but did not influence its leaders to act differently.

The history of savings and loan associations (often called thrift institutions, thrifts, or S&Ls) goes back hundreds of years in the United States,
but the thrifts became crucially important when returning World War II
veterans rushed out to buy houses. From the post-war housing boom right
up to the mid-1980s, the savings and loan business was a thriving industry, especially in California.

For most of their history, government regulators allowed thrifts to
pay a higher rate of interest than banks were allowed to pay on passbook
accounts, certificates of deposit, or other savings accounts. In return, the
S&Ls were required to lend out most of their money as home mortgages.
They were barred from making business loans or providing most other financial services. In the early 1980s, however, several things happened. Brokerage houses and mutual fund companies-called nonbank banksstarted offering money market accounts at an unregulated market interest
rate, and the administration of President Ronald Reagan, with the intention of reducing government's role in business, started deregulating the
thrift industry. The first step was enlarging the industry's lending and
investment powers.

Though Munger is no champion of government regulation, he
thought that the timing and the coordination of deregulation was dangerous. Charlie was irked over the increase in deposit insurance and some
changes in rules for S&Ls, especially since the thrift's new competitors,
the nonbank banks, operated under few regulations. There is no deposit
insurance for their money market funds and fund owners, unlike thrifts,
are not required to maintain branch offices. Costs to operate money market funds, Munger noted, were more than 50 percent lower than the
annual costs of the most efficient thrifts. These nonbank banks were
skimming the cream off what had once been the S&L's source of funds,
forcing thrifts into a serious profits squeeze. At the same time, deposit insurance gave S&L operators the sense that they could take more risk in
their attempts to ease the pressure.

In his 1983 letter to shareholders, Munger wrote that "an agency of
the U.S. government (the Federal Savings and Loan Insurance Corporation) continues to insure savings accounts in the savings and loan industry, just as it did before. The result may [from expanded loan and
investment powers] well be bolder and bolder conduct by many savings
and loan associations. A sort of Gresham's law (had loan practice drives
out good) may take effect at fully competitive but deposit-insured institutions. If . . . `bold conduct drives out conservative conduct,' there eventually could be widespread insolvencies caused by hold credit extensions
come to grief."2

Munger and Buffett began to divert both Wesco and Mutual Savings
away from the thrift business, preparing Wesco for what was to come.
Wesco purchased 100,000 newly issued shares of Series A Cumulative
convertible Preferred Stocks of Salomon Inc. on October 1, 1987, at a cost
of $100 million. The investment was part of a $700 million transaction, in
which Berkshire purchased $600 million and Wesco bought the remainder. In addition to the 9 percent dividend, each preferred share could be
converted into 26.3 shares of Salomon common on or after October 31,
1990. The way the contract worked, Wesco and Berkshire would make a
profit on the conversion if the shares traded at or above $38.'

As fate would have it, on October 19, 1987, the stock market experienced its worst day in recent history, Black Monday. Salomon was badly hurt by the crash, and its shares fell to as low as $16.62. Fortunately, by
the end of 1989 Salomon common had recovered to $23.38.

In 1988, Munger and Buffett moved Mutual Savings another step
away from its traditional role as a thrift. After a three-hour discussion, the
pair decided to beef up Mutual's small stake in the Federal Home Loan
Mortgage Corporation, commonly called Freddie Mac.

Freddie Mac provides liquidity in the mortgage market by pooling
and packaging home loans into securities that are sold to investors. The
company thus earns fees and "spreads," while side-stepping most interestrate-change risk. Additionally, the company insures mortgages. Freddie
Mac was created by the government in 1938 to make home ownership
more affordable by creating a secondary market for home loans. Over the
years, the character of Freddie Mac changed. Under a charter drafted by
Congress in the midst of a 1970 credit crisis, ownership was limited to
participating lenders, the S&Ls. Later Freddie Mac converted to private
ownership largely held by institutional investors. It began trading on the
New York Stock Exchange in 1988.

Freddie Mac is one of only two federally chartered companies that
package and sell mortgage-backed securities. The other is the Federal National Mortgage Association, commonly called Fannie Mae. The implicit
federal backing for Freddie Mac gave Munger and Buffett the competitive
edge that they like.

Wesco-through Mutual Savings-bought 28.8 million shares of
Freddie Mac for $72 million at a time when Freddie Mac shares could be
lawfully owned only by an S&L. It was the maximum investment in Freddie Mac then allowed by law. It was an investment that built a castle wall
around Wesco during the later collapse of the thrift industry. By the end
of 1999, the Freddie Mac holding had a market value of $1.38 billion.'

"Our experience in shifting from savings and loan operation to ownership of Freddie Mac shares tends to confirm a long-held notion that
being prepared, on a few occasions in a lifetime, to act promptly in scale,
in doing some simple and logical things, will often dramatically improve
the financial results of that lifetime," said Munger. "A few major opportunities clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind, loving diagnosis involving
multiple variables. And then all that is required is a willingness to bet
heavily when the odds are extremely favorable, using resources available
as a result of prudence and patience in the past."