Buffett's bailout headache
The billionaire investor supports federal rescue efforts - even though they're squeezing his Clayton Homes housing finance business.
NEW YORK (Fortune) -- Warren Buffett is no critic of federal aid to the financial system. But the Berkshire Hathaway chief says the government's decision to provide low-cost credit to troubled firms is taking a hefty toll on his Clayton Homes housing finance business.
Buffett has been outspoken in support of the measures policymakers have taken to stop the meltdown of credit markets and the collapse of major financial institutions. "Whatever the downsides may be," Buffett wrote in Saturday's annual letter to Berkshire shareholders, "strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown."
But the past year has been nothing if not a lesson in the unintended consequences of hastily arranged policies, and such is the case with Maryville, Tenn.-based Clayton.
Pretax profit at Clayton tumbled 61% from a year ago in 2008, according to the shareholder letter. But past performance isn't Buffett's big concern.
He wonders instead how Clayton, which was acquired by Berkshire in 2003, will deal with a development that for Berkshire is something of a novel threat: competitors who can borrow even more cheaply.
Berkshire, as Buffett notes, is one of just seven U.S. companies that carry the rating agencies' highest triple-A rating. Higher ratings translate into lower borrowing costs, as lenders demand less compensation for the prospect of default.
For most of the past six years, Clayton -- which also offers financing to buyers of its mobile homes and modular dwellings -- was able to borrow at low Berkshire rates, which gave it lower funding costs than its rivals with lower ratings.
But when the collapse of Lehman Brothers in September froze credit markets, loans became scarce for even the highest-quality borrowers. This threatened the existence of numerous major U.S. financial firms, many of which had met their daily cash needs by borrowing in short-term debt markets.
Policymakers responded with all manner of programs aimed at restoring access to credit, including wholesale guarantees of bank liabilities and special Fed-backed facilities for so-called commercial paper, the unsecured debt that comes due within three months.
While the programs succeeded in restoring some semblance of financial stability, as Buffett notes, they also turned the world upside down for companies like Berkshire that hadn't grown dependent on constant access to short-term, wholesale funding.
"Though Berkshire's credit is pristine -- we are one of only seven AAA corporations in the country -- our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing," Buffett said. "At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one."
The government guarantees -- which cover bonds issued through June -- have benefited giants such as Citi (C, Fortune 500), Goldman Sachs (GS, Fortune 500), Morgan Stanley (MS, Fortune 500) and JPMorgan Chase, among others.
JPMorgan (JPM, Fortune 500), for instance, sold $6 billion worth of bonds last month under a Federal Deposit Insurance Corp. guarantee program. The bonds, which come due in April 2012, were priced to yield 2.11% - less than a percentage point above the going rate for similar-duration Treasury bonds.
Berkshire's Berkshire Hathaway Finance Corp., by contrast, recently sold $250 million of 10-year notes in the private placement market at a yield of 5.4% - 2.4 percentage points above the comparable Treasury bond.
A recent issue of Goldman Sachs bonds not guaranteed by the FDIC -- a rarity among big banks since the FDIC program's November debut -- heightens the contrast. The firm sold a $2 billion issue of 10-year senior global notes last month at 7.79% - 5 percentage points above Treasurys. Berkshire took a $5 billion stake in Goldman last fall.
While all these financial titans have far-flung operations, none of them is known as a major player in manufactured housing. Among Clayton's top competitors in manufactured housing are Fleetwood Enterprises of Riverside, Calif., which is attempting a restructuring and was recently delisted from the New York Stock Exchange, and Champion Enterprises of Troy, Mich., which could be headed for the same fate. Its shares recently fetched 29 cents apiece and haven't closed above a dollar each in more than two months.
Where the bailout hurts Clayton is in its financing arm. The company provides buyers of its homes with mortgages, and growth in its lending business -- together with the company's strong underwriting -- has made Clayton a solid performer even as the market for manufactured housing stalled.
In 2007, for instance, Clayton posted a 3% pretax profit rise, reflecting higher net interest income and lower credit losses in its financing business, even as manufactured home sales slipped 5%. Last year, Clayton's home sale revenue dropped, but its interest income on installment loans rose.
With the housing business in even steeper decline and the credit markets locked up for much of the second half of 2008, pretax profit at Clayton plunged to $206 million from $526 million a year earlier. That result had Buffett hoping in Saturday's letter for a return to normalcy.
"Today's extreme conditions may soon end. At worst, we believe we will find at least a partial solution that will allow us to continue much of Clayton's lending," he wrote. "Clayton's earnings, however, will surely suffer if we are forced to compete for long against government-favored lenders."
(A member of FORTUNE's staff, senior editor at large Carol Loomis, edits the chairman's letter in Berkshire's annual report.)
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