Warren Buffett on Credit Cycles

Chairman and CEO Stephen Squeri opened the Q4 2023 review by reporting full-year revenues net of interest expense of $60.5 billion, up fourteen percent year over year, and earnings per share of $10.60. Management told the call that billed business grew ten percent on a currency-neutral basis, with the premium-cohort Cards - the Platinum, the Gold and the Business Platinum - growing billings at high-single-digit to low-double-digit rates despite the macroeconomic softness that emerged in the back half of the year. CFO Jeff Campbell walked analysts through the credit metrics, acknowledging that write-offs on the Card Member loans portfolio had normalised upward from the unsustainably low levels of 2021 and 2022 to a level roughly in line with the 2019 baseline. He flagged that the Company had built approximately $1.2 billion of incremental reserves during the year under the CECL regime, but that the underlying delinquency drift had been concentrated in the small-business and consumer credit-card segments rather than in the premium proprietary franchise. On the Q&A, analysts pressed on whether the credit normalisation implied that the premium customer was finally showing signs of stress. Squeri responded that the high-spend proprietary Cards had continued to grow billings faster than the Company average, that the FICO profile of the new accounts being acquired was actually higher than the existing book and that the underwriting discipline installed after the 2008 cycle had held up through the rate-shock environment. He also reiterated the long-term revenue growth algorithm of ten percent plus and the mid-teens earnings growth algorithm, anchored on the durability of the network and the premium proprietary franchise. The call closed with management introducing 2024 guidance of earnings per share between $12.80 and $13.80, framed as the midpoint of the long-term algorithm, and signalling that the Company intended to return roughly 100 percent of operating free cash flow to shareholders through the cycle.

Moynihan opened the Q4 2023 review by reporting full-year net income of $26.2 billion and a return on tangible common equity of approximately fifteen percent, with the fourth quarter adjusted net income of $7.1 billion representing the strongest quarter of the year. Management told the call that the consumer deposit franchise had continued to grow despite the regional bank deposit migration that had followed the Silicon Valley Bank and Signature Bank failures in March, and that the Bank had absorbed the FDIC special assessment without breaching the operating earnings power. CFO Alastair Borthwick walked analysts through the net interest income trajectory, indicating that the rate-driven tailwind had stabilised during the quarter and that the outlook for 2024 net interest income saw modest sequential declines as the asset sensitivity of the balance sheet normalised. He flagged that trading revenue had been the second-highest fourth quarter in the Bank's history, that the wealth management franchise had produced positive operating leverage and that the Bank had returned approximately $24 billion of capital to shareholders during the year, including a roughly eight percent increase in the common dividend and a meaningful share repurchase activity authorised under the 2023 CCAR cycle. On the Q&A, analysts pressed on whether the deposit migration that had moved from the regional banks to the money-centre banks during the spring had stabilised or was continuing. Moynihan responded that the deposit balances had stabilised through the back half of 2023, that the uninsured deposit base had been broadly retained and that the Bank was continuing to grow primary consumer checking accounts at mid-single-digit rates. He also pushed back on the suggestion that the net interest income trajectory into 2024 implied a structural compression of the earnings power, arguing that the wealth management and investment banking franchises were positioned to offset the decline in asset sensitivity over the cycle. The call closed with management reaffirming the long-term operating framework of mid-teens return on tangible common equity, positive operating leverage and a return of essentially all of the operating earnings power to shareholders subject to the CCAR cycle, and with the Bank committing to step up the share repurchase pace during 2024 as the CET1 ratio moved through the targeted operating range.

Chenault's successor, Stephen Squeri, opened the Q2 2020 review by reporting that second-quarter revenues net of interest expense had fallen nearly thirty percent year over year, reflecting the collapse of travel-and-entertainment spend that historically accounted for a disproportionate share of Amex billings. Management told the call that the small-business and consumer services segments had partially offset the T&E collapse, and that the Company had moved aggressively during the quarter to defer marketing, reduce operating expenses and tighten underwriting on new accounts and on existing credit lines. CFO Jeff Campbell walked analysts through the $1.5 billion pre-tax credit provision taken during the quarter, of which approximately $1.2 billion represented reserve builds under the new CECL accounting regime. He flagged that the Company had suspended share repurchases during the quarter, retained capital to absorb the forward expected losses and continued to pay the common dividend, but would not restart buybacks until visibility on credit losses and T&E recovery improved. On the Q&A, analysts pressed on whether the COVID shock would structurally compress the T&E franchise in the way the post-9/11 shock had compressed corporate travel. Squeri argued that the early data from the May and June reopenings, especially the small-business and consumer services segments, suggested a faster recovery path than the post-9/11 trajectory and that the Company's premium Card Member cohort was holding spending better than the broader consumer. He also highlighted that the underlying merchant network had not contracted during the crisis, with the acceptance footprint expanding on net. The call closed with management declining to provide formal full-year guidance given the unresolved visibility on the pandemic path, but committing to a near-term priority of protecting the dividend, preserving capital and protecting the marketing investment behind the premium brand once the cycle turned.

Moynihan opened the Q2 2020 review by reporting net income of $3.5 billion despite absorbing roughly $4.2 billion of incremental credit loss provisions under the CECL accounting regime. Management told the call that the consumer deposit franchise had grown balances by more than twenty percent year over year, that the Paycheck Protection Program originations had reached approximately $32 billion across roughly 300,000 small-business borrowers and that the trading business had reported the highest quarterly revenue in nearly a decade on the volatility surge in March and April. CFO Paul Donofrio walked analysts through the reserve build, explaining that approximately $2.5 billion of the provision had been driven by the macroeconomic forecast adjustments under CECL rather than by actual delinquency migration. He flagged that net charge-offs had remained below pre-pandemic run-rate levels, that the loan deferral balances in the consumer and commercial books were beginning to roll off and that the Bank had continued to hold capital well above the regulatory minima, allowing the common dividend to be maintained even while share repurchases had been suspended. On the Q&A, analysts pressed on whether the Bank would need to build reserves further through the back half. Moynihan responded that the second-quarter build had been sized to reflect a macroeconomic baseline consistent with the consensus forecast and that subsequent builds would depend on whether the actual delinquency migration tracked the forecast. He also defended the decision to maintain the dividend, arguing that the Bank's earnings power through the cycle supported the distribution and that the Federal Reserve's guidance to suspend buybacks was the more meaningful constraint on capital return during the year. The call closed with management framing the next phase as a measured resumption of capital return subject to Federal Reserve guidance, while continuing to invest in the consumer mobile banking platform that had seen login activity grow more than twenty percent during the quarter and to support the broader Federal Reserve lending facilities as the standing balance sheet permitted.

Moynihan opened the Q4 2016 review by reporting financial results that reflected the immediate aftermath of the November 2016 U.S. presidential election and the corresponding sharp back-up in long-term interest rates. Management told the call that net interest income in the fourth quarter had been the highest in five years, that the deposit franchise had continued to grow at mid-single-digit rates while paying effectively nothing on the marginal deposits and that the trading business had seen its strongest fourth quarter in years on the volatility surge. CFO Paul Donofrio walked analysts through the rate-sensitivity disclosure, indicating that a 100 basis point parallel shift in the yield curve would generate approximately $5.3 billion of incremental net interest income over the following twelve months, with the bulk of the benefit concentrated in the first half. He flagged that the Company had moved its Common Equity Tier 1 ratio above ten percent and that the Federal Reserve had approved a capital plan including an incremental $5 billion share repurchase authorization in the 2016 CCAR cycle. On the Q&A, analysts pressed on whether the Bank would lean into share repurchases given the rate-driven earnings power accreting through 2017. Moynihan responded that the Bank's preference was to return essentially all of the operating earnings power to shareholders subject to the CCAR approval, that the share count had been reduced in absolute terms during 2016 for the first time since the crisis and that the Bank intended to continue the trajectory of buying back stock at a faster pace as the rate-driven net interest income normalised. The call closed with management framing 2017 as a year of operating leverage, with the rate-driven net interest income lift and the expense discipline combining to drive a return on tangible common equity back toward the mid-teens target that had been the multi-year objective of the post-crisis transformation.

The Street’s denizens are always ready to suspend disbelief when dubious maneuvers are used to manufacture rising per-share earnings, particularly if these acrobatics produce mergers that generate huge fees for investment bankers. Auditors willingly sprinkled their holy water on the conglomerates’ accounting and sometimes even made suggestions as to how to further juice the numbers. For many, gushers of easy money washed away ethical sensitivities. Since the per-share earnings gains of an expanding conglomerate came from exploiting p/e differences, its CEO had to search for businesses selling at low multiples of earnings. These, of course, were characteristically mediocre businesses with poor long-term prospects. This incentive to bottom-fish usually led to a conglomerate’s collection of underlying businesses becoming more and more junky. That mattered little to investors: It was deal velocity and pooling accounting they looked to for increased earnings. The resulting firestorm of merger activity was fanned by an adoring press. Companies such as ITT, Litton Industries, Gulf & Western, and LTV were lionized, and their CEOs became celebrities. (These once-famous conglomerates are now long gone. As Yogi Berra said, “Every Napoleon meets his Watergate.”) Back then, accounting shenanigans of all sorts – many of them ridiculously transparent – were excused or overlooked.

CEO Brian Moynihan opened the Q3 2011 review against the backdrop of the Berkshire Hathaway $5 billion preferred equity investment and the attached warrants to purchase 700 million common shares at an exercise price of $7.14, both announced in late August. Management told the call that the third-quarter results had been hampered by a $3.6 billion pre-tax charge tied to the legacy Countrywide mortgage representation-and-warranty exposures, but that the underlying franchise was now generating operating earnings power roughly in line with the stated objective of the Project New BAC restructuring. CFO Bruce Thompson walked analysts through the third consecutive quarter of operating expense reduction, the build of the capital ratios under the new Basel III regime and the roughly 140 basis points of tangible common equity ratio build achieved during the quarter. He flagged that the Berkshire transaction had been structured to monetise a portion of the embedded franchise value at favorable terms rather than to fill a capital hole, and that the Company remained on a path to exceed the new capital requirements ahead of the regulatory phase-in. On the Q&A, analysts pressed Moynihan on whether the Berkshire transaction implied that the Company would need to issue additional common equity to close the remaining capital gap. Moynihan responded categorically that the preferred investment had been opportunistic, that the warrants were a long-dated option rather than an equity issuance and that the Company did not intend to issue common equity to meet the new capital requirements, pointing to the asset disposition program and the operating expense trajectory as the bridge. The call closed with management reiterating the multi-year Project New BAC objective of removing $8 billion of operating expense from the run-rate by mid-decade, and with Moynihan committing to a transparent disclosure of the legacy mortgage litigation pipeline so that investors could value the franchise against the underlying consumer banking business rather than against the trailing issues.

Indeed, many families that couldn’t afford to buy an appropriate home a few years ago now find it well within their means because the bubble burst. The second reason that manufactured housing is troubled is specific to the industry: the punitive differential in mortgage rates between factory-built homes and site-built homes. Before you read further, let me underscore the obvious: Berkshire has a dog in this fight, and you should therefore assess the commentary that follows with special care. That warning made, however, let me explain why the rate differential causes problems for both large numbers of lower-income Americans and Clayton. The residential mortgage market is shaped by government rules that are expressed by FHA, Freddie Mac and Fannie Mae. Their lending standards are all-powerful because the mortgages they insure can typically be securitized and turned into what, in effect, is an obligation of the U.S. government. Currently buyers of conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 5 1⁄4 %. In addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an action that also helped to keep rates at bargain-basement levels. In contrast, very few factory-built homes qualify for agency-insured mortgages. Therefore, a meritorious buyer of a factory-built home must pay about 9% on his loan. For the all-cash buyer, Clayton’s homes offer terrific value.

Kovacevich opened the Q4 2008 review against the backdrop of the early October announcement of the all-stock acquisition of Wachovia Corporation, completed at year-end at a deep discount to Wachovia's stand-alone book value. Management told the call that the merger would create the first coast-to-coast retail banking franchise in the United States, that the integration would be executed off the proven Norwest-Wells Fargo playbook and that the credit marks taken at acquisition accounted for the worst-case stress on the Wachovia loan portfolio, including the option-ARM portfolio inherited from Golden West Financial. CFO Howard Atkins walked analysts through the capital framework, indicating that the Company had issued $25 billion of preferred stock to the U.S. Treasury's Capital Purchase Program to bridge the closing of the Wachovia acquisition and that the operating earnings power of the combined franchise would generate enough internally generated capital to repay the Treasury investment within a few years. He flagged that the integration expenses would weigh on the near-term reported earnings but that the merger synergies were expected to exceed $5 billion annually once the integration was completed. On the Q&A, analysts pressed on whether the option-ARM portfolio represented a hidden credit risk that would force the Company to build reserves further. Kovacevich responded that the marks taken at acquisition had been sized for a severe housing price decline and that the early delinquency migration in the option-ARM portfolio was tracking inside the stress assumptions. He also pushed back on the suggestion that the Treasury investment implied a capital weakness, arguing that the Company had entered the Wachovia transaction from a position of strength and that the Treasury investment had been taken under regulatory pressure rather than out of necessity. The call closed with management framing the next phase as the largest integration in the history of U.S. banking and reaffirming the long-term objective of cross-sell-driven revenue growth, mid-teens return on equity and a sustained pace of share repurchases once the Treasury investment was repaid and the integration was complete.

At the Berkshire annual meeting in May 2008, the financial crisis was already underway but had not yet reached its climax. I told the audience that the credit cycle had turned, that the easy money that had fuelled the housing bubble was gone, and that the unwind would take years rather than months. The mistakes that had been made during the boom were the standard ones: lenders had underwritten loans on the assumption that house prices would keep rising, ratings agencies had stamped triple-A on bonds whose underlying collateral was suspect, and investors had bought those bonds on the assumption that the ratings agencies knew what they were doing. The cycle had taught me, once again, that credit is a pendulum. It swings from abundant to scarce with a violence that surprises everyone who had grown comfortable during the easy phase. The investor who survives the swing is the one who has positioned his balance sheet for the scarce phase before it arrives. The contrarianism angle was the one that mattered most. I told the meeting that the worst time to sell a stock was during the panic phase of a credit cycle, and the best time to buy was during the same panic. Most investors, however, do the opposite: they buy during the easy phase because prices are rising, and they sell during the scarce phase because prices are falling. The investor who can invert that pattern, who can buy when the headlines are terrifying and refuse to sell when his neighbours are panicking, has an enormous long-run advantage. I had been buying throughout the crisis, both for Berkshire and for my personal account. The reason was simple: the prices being offered for wonderful businesses were absurdly low, and the long-run returns from buying wonderful businesses at low prices are very high. The discipline required was patience, and the resource required was a balance sheet strong enough to absorb short-term paper losses without being forced to sell. The credit-cycles lesson I have repeated most often is that the pendulum always swings back. The credit cycle does not end in scarcity; it ends in abundance, when lenders, having forgotten the losses of the previous scarcity, begin lending freely again to borrowers who cannot repay. The investor who recognises this pattern, and who positions his portfolio for the next phase of the cycle rather than for the current phase, has an enormous advantage over the investor who assumes the current phase will continue forever. The 2008 crisis was, in this sense, no different from the 1990 savings-and-loan crisis, the 1998 Long-Term Capital Management crisis, or the 2000 dot-com unwind. The names of the assets change; the underlying psychology does not. The investor who memorises that single observation, and who acts on it with patience and a strong balance sheet, will outperform the elaborate risk-management models of the largest banks in nearly every cycle.

Chairman and CEO Ken Chenault opened the Q4 2008 review by acknowledging that the Company had entered the worst consumer credit cycle since the early 1990s recession and that American Express had moved during the fourth quarter to materially tighten underwriting, reduce credit lines and reprice risk where the data warranted. Management reported that reported earnings per share for the year had fallen by more than thirty percent, with most of the deterioration concentrated in the Card Member loans segment, where net write-offs had moved above eight percent on a managed basis. CFO Gary Crittenden walked analysts through the $1.4 billion pre-tax charge taken during the fourth quarter, comprising roughly $800 million of incremental loan-loss reserves, $400 million of severance and restructuring and the balance of writedowns tied to the investment portfolio. He flagged that the restructuring would remove more than $1.8 billion of operating expense from the run-rate by 2010 and that the Company had secured a one-year equity injection of approximately $3.4 billion from the U.S. Treasury's Capital Purchase Program to bridge the cycle. On the Q&A, an analyst asked whether the high-end spending customer had actually held up better than the broader consumer. Chenault responded that the high-spend Card Member cohort had seen far less delinquency drift than the broader book, that the proprietary spend data had allowed Amex to take earlier and more targeted underwriting actions than the broad bank-card issuers and that the brand's premium positioning was itself a structural advantage through a downturn, even though it could not fully insulate the Company from a synchronised consumer recession. The call closed with management signalling that 2009 would be a transition year of flat billings, sharply lower credit metrics and operating expense reduction, and that the Company's long-term algorithm of mid-teens return on equity and high-single-digit earnings growth would be reaffirmed once the cycle turned.

Truly outsized risks will exist in these contracts if they are not properly priced. A pernicious aspect of catastrophe insurance, however, makes it likely that mispricing, even of a severe variety, will not be discovered for a very long time. Consider, for example, the odds of throwing a 12 with a pair of dice -- 1 out of 36. Now assume that the dice will be thrown once a year; that you, the "bond-buyer," agree to pay $50 million if a 12 appears; and that for "insuring" this risk you take in an annual "premium" of $1 million. That would mean you had significantly underpriced the risk. Nevertheless, you could go along for years thinking you were making money -- indeed, easy money. There is actually a 75.4% probability that you would go for a decade without paying out a dime. Eventually, however, you would go broke.

Chairman Harvey Golub's third-quarter 1991 review came at the moment the Salomon Brothers Treasury-auction scandal had metastasised into a broader confidence crisis across the brokerage arm American Express still controlled through its Shearson Lehman Holdings subsidiary. Management told the call that the Company's core Travel Related Services franchise had continued to grow billings business across both the green-card and the Optima revolving credit product, but that earnings would be obscured in the near term by the additional capital and reserve actions required at Shearson. CFO Michael Mortella walked analysts through the planned $1.4 billion charge to restructure the brokerage arm and to recapitalise the leasing portfolio that had been the source of recurring credit losses. He framed the actions as a deliberate decision to surface the worst-case loss expectations in a single quarter, so that the underlying TRS franchise could be valued on its own merits going forward rather than against the dragging uncertainty of the brokerage book. On the Q&A, analysts pressed on whether the Salomon crisis and Shearson losses would force the Company to issue equity to defend its capital ratios. Golub responded that the dividend on the common stock would be maintained, that the Company would continue to buy in shares opportunistically and that the charge had been sized to remove the optionality of further equity issuance from the brokerage subsidiary. He argued that the Optima revolving product was the more important strategic variable for the long-term value of the Company and would receive disproportionate investment in 1992. The call closed with management declining to provide formal quarterly guidance but committing to a multi-year trajectory of restoring return on equity to the mid-to-high teens, anchored on the durability of the card-fee and discount-revenue economics that had defined the Company's brand strength for a century.