What Warren Thinks...

Buffett invites groups of business students to his house a dozen or so times a year to do a Q&A, have lunch at the local eatery, then do photo-ops. Fortune Magazine got to witness one such event recently. Afterwards the reporter had some alone time. Most revealing answer into how fucked up the financial system is (the question was "Do you find it striking that banks keep looking into their investments and not knowing what they have?"):

I read a few prospectuses for residential-mortgage-backed securities - mortgages, thousands of mortgages backing them, and then those all tranched into maybe 30 slices. You create a CDO by taking one of the lower tranches of that one and 50 others like it. Now if you're going to understand that CDO, you've got 50-times-300 pages to read, it's 15,000. If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared, you're now up to 750,000 pages to read to understand one security. I mean, it can't be done. When you start buying tranches of other instruments, nobody knows what the hell they're doing. It's ridiculous. And of course, you took a lower tranche of a mortgage-backed security and did 100 of those and thought you were diversifying risk. Hell, they're all subject to the same thing. I mean, it may be a little different whether they're in California or Nebraska, but the idea that this is uncorrelated risk and therefore you can take the CDO and call the top 50% of it super-senior - it isn't super-senior or anything. It's a bunch of juniors all put together. And the juniors all correlate.

He always says never to invest in a company if you don't understand it. He's saying that not even the bank understands its own securities instruments. But, important to note is that he's not advocating more government regulation to protect investors or even consumers. Even the 200 employees of the Office of Federal Housing Enterprise Oversight (OFHEO), whose sole job it is to oversee Fannie Mae and Freddie Mac, couldn't catch two of the biggest accounting misstatements in history. There are just too many counterparts to each part of those companies, counterparts that cross into other companies and other investors, across international borders. Just an idea of how complicated this whole mess really is.

Hunker down, people; we're in for a long, bumpy ride.