The 1980s would be an era of deals—most financed with debt. The Dow hadn’t budged in seventeen years.1 Grinding inflation had decimated corporate profits, yet companies dribbled away their earnings in sloppy operations and unthinking bureaucracy.2 By the early 1980s, stocks were on sale like polyester suits. Then, under Federal Reserve Chairman Paul Volcker, interest rates, recently an astronomical fifteen percent, started to fall as inflation came under control. With debt now cheap, would-be buyers of a company could use the company’s own soon-to-be-gutted assets as collateral to finance its purchase—like getting a hundred percent mortgage on a house. It cost no more to buy a huge company than to set up a lemonade stand.3 The merger boom had begun.
In 1984, the burner under managements turned up another notch when “junk bonds” became respectable. More politely called “fallen angels,” these were the bonds of companies like the Penn Central Railroad that were climbing out of the bankruptcy dustbin or teetering on its edge.4 Only occasionally did a company issue junk bonds on purpose, paying a high interest rate because it was considered a dicey credit risk. Junk bonds were sort of shady, a little desperate.
Everything changed when Michael Milken, of the upstart investment bank Drexel Burnham Lambert, rose to become the most influential man on Wall Street through a simple proposition: that while individual “fallen angel” junk bonds were risky, through the law of averages, buying a bushel of them was not.
Soon, money managers felt at ease putting high-paying junk bonds in their portfolios. Indeed, it quickly became more respectable to issue new junk bonds—quite a different thing. Another short hop and takeovers of strong, well-financed companies could be financed with junk. Corporate raiders intent on “hostile takeovers” whose goal was to pluck a company clean suddenly stalked companies that had been waddling along complacently. Their targets lunged toward any buyer who might conceivably be more friendly; in the end the target company was usually sold to someone or another and financially gutted. This orgy of mergers that often took place with the consent of only one party riveted the public; clashes of titanic egos filled the daily papers. Michael Milken’s annual junk-bond conference, the Predators’ Ball,5 lent its name to the entire era.
Buffett scorned the way these deals transferred riches from shareholders to managers and corporate raiders, helped by a long, long line of toll-taking bankers, brokers, and lawyers.6 The deals of the 1980s repelled him above all because they were loaded with debt. To him, debt was something to be used only with a careful eye for the worst-case scenario. In the 1980s, however, debt became mere “leverage,” a way of boosting profits using borrowed money. “Leverage” arrived at the same time that the U.S. government began running large deficits courtesy of “Reaganomics”—the “supply-side” idea that cutting taxes would ultimately increase tax revenues by stoking the economy. Fierce debates raged among economists over whether tax cuts could actually pay for themselves and, if so, by how much. The economy was heating up at the time from consumer spending, also fueled by debt; John and Jane Q. Public had gradually been accustoming themselves to buying everything with credit cards, building up a balance that they would never pay off until from their plastic death did them part. The Depression-era culture of hoarding and saving had turned turtle, into a culture of buy now, pay later.
Buffett still paid cash and chose the role of the white knight in takeovers. Early one morning in February 1985, while he was in Washington, Tom Murphy called and woke him to say he had just bought the ABC television network. ABC, caught in the crosshairs of the corporate raiders, had hung a lure out to see whether Murphy would save it by doing a friendly deal—and Murphy bit.7
“Think about how it will change your life,” Buffett said. Buffett may well have been thinking about the incongruity between the modest, retiring Murphy, a devout Catholic, and the glamorous world of television, as Murphy believed8—but Buffett’s next move signaled that he wouldn’t mind such a change himself. Or so it seemed, since he recommended to Murphy that Cap Cities/ABC recruit a “gorilla” investor who could protect it from the raiders’ attentions. To no one’s surprise, Murphy suggested that this investor should be Buffett himself. Likewise, Buffett had no trouble quickly agreeing to spend $517 million of Berkshire’s money for fifteen percent of Cap Cities.9
Buffett now became a player in the biggest media deal in history. At a total of $3.5 billion, he and Murphy had paid a fancy price for ABC.10 “The network business is no lollapalooza,” Buffett would later say.11 Yet he had watched the awesome ascendance of television from its infancy and knew well both its power to shape public opinion and its business potential. Buffett wanted Cap Cities/ABC so much that he was willing to leave the board of the Washington Post to comply with FCC regulations limiting the two companies’ television interests through related entities.12
The year 1985 would be a humdinger. During the same week that Buffett’s investing yielded Berkshire $332 million from a single stock—General Foods, when it was taken over by Philip Morris—Forbes caught on to how rich he was and added him to its list of America’s 400 richest people. At the time, it took $150 million to make that list. But Buffett, at age fifty-five, was now a billionaire, one of only fourteen ranked by Forbes.
Berkshire Hathaway, its first few shares originally bought for $7.50, was now trading at more than $2,000 a share. But Buffett refused to “split”* the stock into smaller pieces, citing the way brokerage fees would multiply needlessly along with the number of shares. This policy made Berkshire more like a partnership—or even a club—and the high stock price drew attention to Berkshire like nothing else.
His fame ascended with Berkshire’s stock price. Now when he entered a room of investors, an energy filled the air as attention gravitated toward him. The purchase of ABC by Cap Cities did indeed begin to change his life. Meeting soap opera impresario Agnes Nixon, he got invited to do a gig on the show Loving. A lot of CEOs would have feigned a mortal illness before doing something so undignified, but Buffett loved doing his cameo on Loving so much that he showed off the paycheck from his show-business debut. It was all of a piece with the Buffett who loved to play dress-up and would soon be appearing costumed as Elvis at his friends’ parties. This same Buffett reveled in putting on black tie to take Susie Jr. to a state dinner at the Reagan White House. Jetting off to the Academy Awards with Astrid—who made a rare public appearance, proudly wearing a thrift-shop gown—he dined with Dolly Parton. But Buffett, who found Parton likable as well as hugely attractive, failed to make the lasting impression on her that he managed with most other women.
At the Kay Parties, where Graham always seated him between the two most important or interesting women, he did better. Yet he had never grown to love small talk, and found it challenging—or just plain tiresome.
“The truth is, you’re sitting next to two people that you’ve never seen before and you’re never going to see again. It’s kind of strained, no matter what. Whether it was Babe Paley, or Marella Agnelli, or Princess Di, Kay always saw in these women what she aspired to be. I didn’t have the faintest idea what to talk about. Princess Di was not as easy to talk to as Dolly Parton. What do you say to Princess Di—‘How’s Chuck? Anything new at the castle?’ ”
Still, by 1987 a billionaire commanded a certain cool respect; Buffett had become something of an elephant himself, no longer so dependent on Graham. And Graham no longer needed him so much as a regular escort, for their mutual obsession had cooled. Now her attraction to powerful men had heated up her longtime friendship with the recently widowed, paper-dry, encyclopedically brilliant, alpha-squared Robert McNamara, who had been defense secretary during the Kennedy and Johnson administrations. Before long, McNamara became Graham’s “Husband Number Three,” as one of her board members referred to him. True to form, she put him on the Post board. From the beginning, McNamara and Buffett “were not the best of friends,” though over time, their relationship resolved into a sort of mutually respectful truce.
Buffett could handle people like McNamara through diplomacy; a greater problem was the physical danger that accompanied his fame. Two men arrived at Kiewit Plaza, one waving a chrome-plated replica of a .45, intending to kidnap Buffett and hold him for $100,000 ransom.13 The building security and police handled it. Afterward, Buffett would not hear of hiring a bodyguard, for that would restrict his cherished privacy and freedom, but he did have a security camera installed, along with a three-hundred-pound security door to shield the office.14
Strangers called often now, insistent, wanting to speak with him. Gladys told them in crisp tones to write a letter spelling out their requests.15 A lot of letters said, I’ve gotten in over my head with credit cards or gambling debt.16
Buffett the collector kept the letters; they began to fill up his files. Many of them confirmed the way he thought of himself, as a role model, as a teacher. Occasionally, he wrote a debtor or gambler back with firm but kind insistence that they take responsibility for their problems. As if they were his kids, he suggested they buy time to bail themselves out by telling their creditors how broke they were and negotiating easier payment terms. He always added a little soliloquy about the perils of too much debt—especially debt from credit cards, the junk bonds of the personal-finance world.
His own kids had received little such training about how to handle money—and their father remained inflexible about requests for money from them. He was still willing, however, to make financial deals with family members to manage their weight.
The thirty-something Susie Jr. struggled with a few extra pounds. Her father made a deal in which, for losing a certain amount of weight, she could shop for clothes for a month, no limit. The only catch was that she had to pay him back if she regained the weight in a year. This deal was better than the proverbial win/win: It was a no-risk deal in which Buffett won either way. He was out the money only if Susie Jr. did as he wanted and kept the weight off. So Susie Jr. dieted, and when she got down to the goal weight, Big Susie mailed credit cards to her daughter with a note—“Have fun!”
Susie Jr. dared not spend a dime at first, frightened by the thought of asking her father to pay the bills. Bit by bit she worked herself up, until finally she shopped in the blind daze induced by having unlimited money for the first time in her life, tossing the receipts unread each day on the dining-room table, too afraid to add the total. “Oh, my God!” said her husband, Allen, each night as he returned home to his wife’s mounting pile of sales slips. After thirty days, she added them up. She had spent $47,000.
“I thought he was going to die over how much it was,” she says of her father. Susie Jr. went for reinforcement. Her mother was powerful, but she knew who had even more leverage with Warren when it came to money. While Kay Graham barely knew Peter and was an “unreachable” figure to Howie—he was always afraid he would sit in the wrong place or break something in her house—Susie Jr. had developed a warm, close relationship with her.17 She called Graham, who agreed to parachute in as backup if needed. But since a deal was a deal, Buffett paid the bill without strong-arming.
The rent that Buffett charged Howie for his farm similarly rose and fell with his son’s poundage. Warren thought Howie should weigh 182.5 pounds. When Howie was over the limit, he had to pay twenty-six percent of the farm’s gross receipts to his father. When he was under, he paid twenty-two percent. “I don’t mind it, really,” Howie said. “He’s showing he’s concerned about my health. But what I do mind is that, even at twenty-two percent, he’s getting a bigger paycheck than almost anybody around.”18 So Warren couldn’t lose on this deal either. He got either more money or a thinner son.19 All of this was classic Buffett. As one of his friends put it, “He’s the master of win/win … but he never does anything that isn’t a win for him.”
Peter and his family had moved from their apartment on Washington Street, in the building where his mother now lived, to a house on Scott Street. Peter got a gig writing music for some fifteen-second animated spots for a new cable channel, MTV. Success led to a business scoring commercials. Even though Peter was the least financially savvy of the Buffett kids, he had managed to tether his Berkshire stock to his musical talent and thus establish a career that freed him from the money games. He realized that if he wanted to pursue his own art, he needed to free himself from corporate lackeyship. While he continued doing commercial work, he cut a demo record and signed with the New Age label Narada to do an album.20
His mother, who still dabbled in music, was often at Peter’s studio, but in 1984 she had some more health problems, including a painful abscess between the spleen and pancreas, and was hospitalized for exploratory surgery. Her doctors could find no cause, and she recovered without incident. She then continued her work as a “mobile Red Cross unit,” as one family member put it, at her usual frenetic pace. Her self-image was as the healthy person whose role was to care for others. She threw masquerade parties in her tiny place on Washington Street, tried to learn to ride a bicycle, and gathered her impromptu family of gays and strays at large dinner parties and Thanksgiving celebrations. She wore jeans and sweatsuits and put away the wigs she had once worn, her hair now a lighter brown, released into a corona around her beaming face.
Warren—who would give his wife almost anything she asked for these days—let her expand and redecorate the Laguna house. She met Kathleen Cole, an interior designer, and together they began to give it the bright-colored contemporary look that Susie favored.21 Susie and Warren continued to spar over money, but these spats had become almost scripted: Susie’s allowance expanded at an accelerating pace—although never at the rate she wanted. She could afford Cole’s services and those of a full-time secretary to manage her schedule, which freed her to extend herself further while also spending more time with the family. Howie remained the magnet who drew more of her support and energy than anyone else. She commuted back and forth to Nebraska to help with this and that and to lavish affection on Howie’s children, her adopted granddaughters Erin, Heather, Chelsea, and Megan, and grandson Howie B.
When Susie Jr., who lived in Washington, D.C., became pregnant with her first child, Big Susie began making more trips to the East Coast. Susie and Allen needed to remodel their little house. It would cost $30,000. She considered how to pay for it, since she and Allen didn’t have the money; she knew better than to ask her billionaire father to give it to her. Fortunately, her pregnancy had activated the one loophole in her weight deal with her father. Buffett was not getting his $47,000 back. Nevertheless—despite her father’s belief that clothing holds its value better than jewelry—she and Allen could not hock her new wardrobe to pay for the kitchen. So she asked her father for a loan.
“Why not go to the bank?” he asked, and turned her down. Unearned position, inherited wealth drove Buffett crazy, offended his sense of justice, and disturbed his sense of the universe’s symmetry. But applying such strictly rational rules to his own children was a chilly way to look at the world. “He won’t give it to us on principle,” said Susie. “All my life, my father has been teaching us. Well, I feel I’ve learned the lesson. At a certain point, you can stop.”22
Before long, her doctor confined Susie Jr. to bed rest for a tedious six months. She lay in a tiny bedroom watching a small black-and-white television set. An appalled Kay Graham brought over meals prepared by her chef, then shamed Buffett into buying his daughter a larger color TV. When Big Susie caught wind of what was happening, she dropped everything and flew in to care for her daughter, spending months in Washington. As soon as she saw the condition of the place, she turned it upside down and renovated it. “It’s just terrible that Warren won’t pay for this,” she complained. But everything she was spending had been dunned out of him. Their endless money game enhanced Warren’s reputation for thriftiness, and Susie’s reputation for generosity. Since they had both signed up for this arrangement, obviously they both wanted it this way.
With the birth of Emily in September 1986, the Buffetts now had eight grandchildren and stepgrandchildren in three cities: San Francisco, Omaha, and Washington, D.C. As the Emerald Bay house renovation reached habitability, Susie slowed the pace to a steady tinkering and began to use it as a base to entertain friends and, especially, her grandchildren. In San Francisco, she hop-scotched into an apartment in Pacific Heights, close to Peter’s new home on Scott Street. This large condominium sat at the top of four dizzying flights of stairs and had a glorious view over the bay from the Golden Gate Bridge to Alcatraz.
Now she hired her decorator, Kathleen Cole, as a personal assistant to help manage her life. “You can just work part-time,” she told Cole, “and you’ll have all this time for your two kids.” The next thing Cole knew, she was working for the Buffett Foundation, planning Susie’s travel arrangements, overseeing entertainment, hiring and managing a staff that included housekeepers, errand-runners, and friends employed partly as a favor, and buying gifts for Susie’s ever-expanding list of beneficiaries.23 She found herself managing two houses, including the ongoing renovation of the Laguna house and the two-year renovation project that Susie had launched on her new place. Cole’s husband, Jim, a firefighter, stepped in as a favor to work as Susie’s part-time handyman. Another friend, Ron Parks, a CPA Susie had met while traveling in Europe, managed the disbursements and taxes—out of kindness and without pay—for what he jokingly called “STB Enterprises,” or, as another friend put it, Susie’s “payroll and give-away roll.”24 Parks was the partner of Tom Newman, her friend Rackie’s son; Susie had become close friends with the couple. Newman, a chef, occasionally helped out with her parties, but mostly tried unsuccessfully to improve her eating habits. By now, Susie’s paid and unpaid staff had far outgrown that at Berkshire Hathaway headquarters.
Warren admired his wife’s desire to rescue people and her skill in helping those in need. As “Mama Susie,” she made it her mission to help people one on one. But the emotional opening-up of this work was beyond Warren. His way of helping people was to leverage his brains and money from a distance to affect as many lives as possible; and he connected to people as a teacher.
Buffett’s earliest teachings had been preserved in the letters he had written to his former partners in the 1960s, letters that were photocopied and passed hand to hand around Wall Street. Ever since 1977, with the help of Carol Loomis, his unusual chairman’s letters to his shareholders in the Berkshire annual reports—carefully crafted, enlightening, eye-opening letters—had grown more personal and entertaining by the year; they amounted to a crash course in business, written in clear language that ranged from biblical quotations to references to Alice in Wonderland and princesses kissing toads. Much of their acreage was devoted to discussions of matters other than Berkshire Hathaway’s financial results—how to think about investing, the harm the dismal economy was doing to business, how businesses should measure results. These letters brought out both the preacher and the cop in Buffett, giving people a sense of him as a man. And the man was charming, he was attractive; his investors wanted more of him. So he gave it to them at the shareholder meetings.
The earliest meetings had taken place in Seabury Stanton’s old loft above the New Bedford mill. Two or three people with Ben Graham connections came because of Buffett. One was Conrad Taff, who had taken Graham’s class. Buffett wanted his shareholder meetings to be open and democratic, as unlike the old Marshall-Wells meeting as possible. Taff peppered Buffett with questions, and Buffett enjoyed it, as if he were sitting in an armchair at a party with people gathered round listening to his wisdom.
The meetings carried on like this for years, with only a sprinkling of people showing up to ask questions, even after the meetings moved to Nebraska and took place in the National Indemnity cafeteria. Buffett still enjoyed them, despite the sparse attendance. As recently as 1981, only twenty-two people attended. Jack Ringwalt actually had to recruit employees to stand in back of the National Indemnity cafeteria so as not to embarrass his boss with an empty room.25
Then in July 1983, coincident with the Blue Chip merger, a little crowd of people suddenly showed up at the cafeteria to hear Buffett talk. He answered them in his plainspoken, unpretentious style: He was teaching, and he came across as democratic, Midwestern, and refreshing, just as he did in his letters to the shareholders.
Buffett spoke in metaphors the audience understood—the emperor’s new clothes, the bird in the hand versus the two in the bush. He told plainspoken truths that other businessmen would not acknowledge, and routinely burst the bubble of corporate double-speak. He developed a memorable way of fabulizing life and businesses into instructive tales that rang true. The meetings took on a quality associated with almost everything that Buffett touched. They began to snowball.
In 1986, Buffett moved the meeting to the Joslyn Art Museum. Four hundred people came, then five hundred the next year. Many of them worshipped Buffett, who had made them rich. In between questions, some people read poems of praise from the balcony.26
Buffett’s anomalous success, and the fame it had brought him, was putting him on the road to becoming a brand just as surely as Skippy peanut butter. Inevitably, therefore, he became the target of a group of finance professors who were at that very moment attempting to prove that someone like Buffett was a mere accident who should not be paid attention, much less worshipped.
These academics believed that the modern-day market was “efficient,” and no one was expert enough to beat it. The many who scrambled to beat the average would, in fact, become the average. Their very efforts to beat the market made the work self-defeating and futile, said Eugene Fama, a professor from the University of Chicago. Yet an army of professionals had sprung up who charged everything from modest fees to the soon-to-be-legendary hedge-fund cut of “two-and-twenty” (two percent of assets and twenty percent of returns) for the privilege of processing trades, managing an investor’s money, and trying to predict the future behavior of stocks. Every year, the sum of all these people’s labors added up to exactly what the market did (less the fees).
Charles Ellis, a consultant to professional money managers, published a book saying that the best way to make money in the market was to simply buy an index of the market itself without paying the high fees that the toll-takers charged.27 Investors would receive the payback from the entire economy’s growth. So far, so good.
The professors who had discovered this efficient-market hypothesis (EMH) kept hacking away at their computers over the years, however, to turn these ideas into an even tighter version. They concluded that nobody could beat the average, that the market was so efficient that the price of a stock at any time must reflect every piece of public information about a company. Thus, studying balance sheets, listening to scuttlebutt, digging in libraries, reading newspapers, studying a company’s competitors—all of it was futile. The price of a stock at any time was “right.” Anybody who beat the average was just lucky—or trading on inside information.
It was certainly true that exceptions to the efficient market had grown rarer. Yet the proponents of EMH denied all exceptions, and to them Buffett—the most visible exception of all—and his lengthening and increasingly acclaimed record became an inconvenient fact. Economists like Paul Samuelson at MIT, Fama at the University of Chicago, Michael Jensen at the University of Rochester, William Sharpe at Stanford, who believed in the “random walk” theory about market behavior, kicked around the Buffett conundrum. Was he a one-off genius or a freak statistical event? A certain amount of derision was heaped on him, as if such an anomalous stunt were not worthy of study. Burton Malkiel, a Princeton economist, summed the whole thing up by saying that anyone who outperformed the stock market consistently was no different from a lucky monkey that had a winning streak at picking stocks by throwing darts at the Wall Street Journal stock listings.28
Buffett loved the Wall Street Journal; he loved it so much that he had made a special deal with the local distributor of the paper. When the batches of Journals arrived in Omaha every night, a copy was pulled out and placed in his driveway before midnight. He sat up waiting to read tomorrow’s news before everybody else got to see it. It was what he did with the information the Wall Street Journal gave him, however, that made him a superior investor. If a monkey got the Wall Street Journal in its driveway every night just before midnight, the monkey still could not match Buffett’s investing record by throwing darts.
Buffett made sport of the controversy by playing with a Wall Street Journal dartboard in his office. The efficient-market hypothesis invalidated him, however. Furthermore, it invalidated Ben Graham. That would not do. He and Munger saw these academics as holders of witch doctorates.29 Their theory offended Buffett’s reverence for rationality and for the profession of teaching.
Columbia held a seminar in 1984 to celebrate the fiftieth anniversary of Security Analysis and invited Buffett to represent the Grahamian point of view at the seminar, which was actually more of a debate over EMH. His opponent on the panel, Michael Jensen, stood up and said he felt like “a turkey must feel at the beginning of a turkey shoot.”30 His role in the morality play was to cast withering comments at the antediluvian views of the Grahamian value investors. Some people could do better than the market for long periods, he said. In effect, if enough people flip coins, a few of them will flip heads over and over. That was how randomness worked.
Buffett had spent weeks preparing for this event. He’d anticipated the coin-flipping argument. When he got up for his turn, he said that while this might be so, the row of heads would not be random if all the successful coin-flippers came from the same town. For example, if all the coin-flippers who kept flipping heads came from the tiny village of Graham-and-Doddsville, something specific that they were doing must be making those coins flip heads.
He then pulled out a chart with the track record of nine money managers from Graham-and-Doddsville—Bill Ruane; Charlie Munger; Walter Schloss; Rick Guerin; Tom Knapp and Ed Anderson at Tweedy, Browne; the FMC pension fund; himself; and two others.31 Their portfolios were not similar; despite a certain amount of coattailing in the early years, they had largely invested on their own. All of them, he said, had been flipping straight heads for more than twenty years, and for the most part had not retired and were still doing it. Such a concentration proved statistically that their success could not have come by random luck.
Since what Buffett said was obviously true on its face, the audience broke into applause and lobbed questions at him, which he answered gladly and at length. The random-walk theory was based on statistics and Greek-letter formulas. The existence of people like Buffett had been waved away using bafflemath. Now, to the Grahamites’ relief, Buffett had used numbers to disprove the absolutist version of the efficient-market hypothesis.
That fall, he wrote up “The Superinvestors of Graham-and-Doddsville” as an article for Hermes, the magazine of the Columbia Business School. Firing a flamethrower at the edifice of the EMH, this article did much to cement his reputation among investors. And over time, the random walkers revised their argument into “semi-strong” and “weak” forms that allowed for exceptions.32 The one great service EMH would have performed, if anybody had listened, was to discourage average people from believing they could outwit the market. Nobody except the toll-takers could object to that. But the tendencies of humankind being what they are, the market went on as before. Thus the main effect of “The Superinvestors of Graham-and-Doddsville” was to add to the growing legend, even the cult, that was building around Warren Buffett.
Meanwhile, EMH and its underpinning, the capital asset pricing model, drove extraordinary and deep roots into the investing world; it launched a view of the stock market as an efficient statistical machine. In a reliably efficient market, a stock was risky not based on where it was trading versus its intrinsic value, but based on “volatility”—how likely it was to deviate from the market average. Using that information and newly unleashed computing power, economists and mathematicians started going to Wall Street to make more money than they ever could in academia.
Knowing a stock’s volatility allowed portfolio managers to pair up stocks and arbitrage them. But to make big money on arbitrage—buying and selling two nearly identical things to profit from their difference in price—required scaffoldings of debt, in which more and more assets were sold short to buy more and more assets on the “long” side.33 This expansion of leverage from hedge funds and arbitrage was related to the rise of junk bonds and takeovers occurring at the same time. The models that supported the argument for leveraged buyouts using junk bonds were, like the models used by arbitrageurs, variations of the efficient-market hypothesis. Leverage, however, was like gasoline. In a rising market, a car used more of it to go faster. In a crash, it was what made the car blow up.
Buffett and Munger defined risk as not losing money. To them, risk was “inextricably bound up in your time horizon for holding an asset.”34 Someone who can hold an asset for years can afford to ignore its volatility. Someone who is leveraged does not have that luxury—the investor may not be able to wait out a volatile market. She is burdened by the “carry” (that is, the cost) and she depends on the lender’s goodwill.
But betting on volatility seemed to make sense when the market rose as predicted. When enough time passes and nothing bad happens, people who are making a lot of money tend to think it is because they are smart, not because they are taking a lot of risk.35
Throughout these profound changes in Wall Street’s ways, Buffett’s own habits had changed little.36 What still made his pulse race was buying a company like Fechheimer, which made prison-guard uniforms. People like Tom Murphy had to worry about whether they would be targeted by corporate raiders wielding junk bonds, but Berkshire Hathaway was impregnable because Buffett and friends of Buffett owned so much of its stock; his reputation made Berkshire a fortress where others could shelter. Berkshire had made $120 million on Cap Cities/ABC in the first twelve months it owned the stock; now the very mention that Buffett had bought a stock could, all by itself, move its price and revalue a company by hundreds of millions of dollars.
Ralph Schey, the head of Scott Fetzer, an Ohio conglomerate, got his company into a jam by trying to take it private in a leveraged buyout. With its stable of profitable businesses, from Kirby vacuums to the World Book encyclopedia, Scott Fetzer made appealing prey, and corporate raider Ivan Boesky quickly intervened to make a bid of his own.
Buffett sent Schey a simple letter saying, “We don’t do unfriendly deals. If you want to pursue a merger, call me.” Schey leaped at the proffer, and $410 million later, Berkshire Hathaway owned Scott Fetzer.37
The next to recognize the power of Buffett’s reputation was Jamie Dimon, who worked for Sanford Weill, the CEO of the brokerage firm Shearson Lehman, an American Express subsidiary.38 American Express wanted to sell its insurance arm, Fireman’s Fund, to Weill in a management buyout. Weill had already recruited Jack Byrne to leave GEICO and run Fireman’s Fund. Dimon approached Buffett to invest his money—and his reputation—in the deal.
Despite their friendship, Buffett was not sorry to lose Byrne. After repairing GEICO’s woes, the perpetually itchy Byrne had embarked on a series of acquisitions and entered into new business lines. Buffett wanted GEICO to concentrate on a sure thing, its core business. Furthermore, he had hired a new chief investment officer for GEICO, Lou Simpson, a retiring Chicagoan who had a distaste for rapid trading and expensive growth stocks. Buffett had added Simpson to the Buffett Group right away, and by now Simpson had become the only person besides himself whom Buffett trusted to invest in other stocks—he allowed Simpson to manage all of GEICO’s investments. But Simpson and Byrne acted like brothers who fought and made up. Periodically, Simpson tried to bolt; Buffett lured him back. Without Byrne, keeping Simpson would be easier.
“Never let go of a meal ticket” was Buffett’s verdict when asked to invest in the Fireman’s Fund deal—and Byrne. American Express decided to cut Weill out of the deal, however, and unload Fireman’s Fund in a public offering, with Byrne as CEO. To keep Buffett on the menu to attract investors, it offered Berkshire a sweetheart reinsurance deal. Buffett took the deal; Weill, feeling double-crossed, blamed Buffett. By some accounts he carried a grudge against Buffett from then on.
From American Express to Sandy Weill, however, the financial world now understood the power of Buffett’s name. At this point, Buffett was tending to so many major investments and advising so many managements that he was either an actual or de facto board member of Cap Cities, Fireman’s Fund, the Washington Post Company, GEICO, and Omaha National Corp. And now he reached a turning point, the moment when he had to consider whether to cross the Rubicon.
Buffett had for some time played a dual role. He ran Berkshire Hathaway as if he still managed money for his “partners”—albeit without collecting any fee. He wrote them letters explaining that he made decisions based on personal criteria; he set up the shareholder contribution program, a personal solution to the problem of corporate giving; he refused to split the stock, had never listed it on the New York Stock Exchange, and considered the shareholders tantamount to members of a club. “Although our form is corporate, our attitude is partnership,” he had written—and meant it. At the same time, he enjoyed living the life of a major-company CEO. Above all, he was now so attached to Berkshire that it had become a virtual extension of himself.
The loosely defined dual role he was playing had so far suited him and his shareholders. Now, however, a decision faced him that required him to choose—he could either run a de facto partnership or continue his role as a major-company CEO. But he could no longer do both.
The reason was taxes. Berkshire was already burdened with corporate income taxes, a cost the partnership had not faced. On the other hand, Buffett charged his Berkshire partners no “fee” to manage their money. That was a good deal (for everyone but Buffett) or at least the shareholders’ loyalty suggests they saw it that way. Now, however, in 1986, Congress passed a major tax-reform act that, among other things, repealed what was called the General Utilities Doctrine. Formerly, a corporation could sell its assets without paying any taxes as long as it was liquidating and distributing the assets to the shareholders. The shareholders would be taxed on their gain, but the gain would not be taxed twice.
Once the General Utilities Doctrine was repealed, any liquidation of a corporation and distribution of its assets would result in a tax on the corporation’s profits and another tax on the shareholders upon distribution. Since the double tax added up to a staggering amount of money, closely held and family corporations all over the country rushed to liquidate themselves before the act went into effect. Buffett, who regularly said in his shareholder letters that Berkshire had gotten so large that its money was a barrier to investing success, could have distributed its assets, then raised a more manageable sum—still in the billions—set up a new partnership, and started over investing within weeks (collecting his fee again, to boot). With $1.2 billion of unrealized profits on Berkshire’s balance sheet, had Buffett liquidated Berkshire, he could have given his shareholders a total tax avoidance of more than $400 million and the chance to start over in a partnership free of the corporate double tax.39 But he didn’t.
Buffett wrote a lengthy dissertation on taxes in his annual letter, in which he addressed this topic and dismissed the idea of liquidating out of hand: “If Berkshire, for example, were to be liquidated—which it most certainly won’t be—shareholders would, under the new law, receive far less from the sales of our properties than they would have if the properties had been sold in the past.”40
The Warren Buffett of old would not have sneered at an extra $185 million in his own bank account and the chance to start over earning fees without the corporate income tax—which is what his decision not to liquidate Berkshire Hathaway in 1986 cost him personally. But ordinary greed no longer drove his decisions—for this cost him far more than any other shareholder. His long-standing attachment to Berkshire held him so firmly in its grip that he gave up the option of keeping Berkshire as a virtual partnership. Otherwise, he would have liquidated without a second’s hesitation.
Instead he had crossed the Rubicon and chosen the role of being the CEO of a major corporation, like Procter & Gamble or Colgate-Palmolive, one that would continue to exist after he was gone.
This company, Berkshire, with its disparate parts, was hard to value. Munger liked to joke that Berkshire was the “Frozen Corporation,”41 since it would grow endlessly but never pay a penny in dividends to its owners. If the owners couldn’t extract any money from their money-making machine, how much was that company really worth?
But Buffett was growing Berkshire’s book value far faster than his shareholders could have accumulated such wealth themselves, and he had the scorecard to prove it. Moreover, it was a long-term scorecard, far more comfortable for him than the year-to-year pressure of beating the market’s bogey. By shutting down the partnership, he had freed himself from that tyranny; in fact he no longer presented numbers in a fashion that allowed someone to calculate his investing performance from inception.42
Yet even though Buffett had now officially joined the CEO club, he had no desire to acquire most of their habits—collecting wine or art, buying a yacht.
There was one exception. One day in 1986, he called his friend Walter Scott Jr., a down-to-earth hometown boy who had worked for Peter Kiewit Sons’, Inc. all his life, just like his father before him. Scott had succeeded Peter Kiewit, then made his reputation during a federal highway bid-rigging scandal that threatened Kiewit’s existence. By forthrightness, “groveling,” and thorough reforms, Scott led the company through a long restoration—a model for dealing with the government in a corporate life-or-death situation.43 He was such a trusted friend of Buffett that Katharine Graham stayed in the Scotts’ apartment on the few occasions that she visited Omaha.
“Walter,” Buffett asked, “how do you justify buying a private airplane?” Buffett knew that Kiewit had a fleet of private jets because it was always having to ferry its employees to remote construction sites.
“Warren,” said Scott, “you don’t justify it. You rationalize it.”
Two days later, Buffett called back. “Walter, I’ve rationalized it,” he said. “Now, how do you hire a pilot and maintain a plane?”
Scott offered to let Buffett piggyback the maintenance of his proposed new jet on Kiewit’s fleet, and Buffett went off and sheepishly bought a used Falcon 20—the same type of plane that Kiewit employees flew—as Berkshire’s corporate jet.44
Of course, buying a private jet conflicted with another of the things he cared most about: not wasting money. Buffett had never lived down an incident in an airport in which Kay Graham had asked him for a dime to make a phone call. He pulled out the only coin he had, a quarter, started to bolt off to get change, but Graham had stopped him by teasing him into letting her waste fifteen cents. So, for Buffett, it was like leaping in one bound over Mount Kilimanjaro to go from justifying twenty-five cents for a phone call to rationalizing two pilots and an entire airplane to carry him around like a pharaoh on a litter. But he was doing a fair amount of rationalizing this year, having just rationalized giving up $185 million in tax avoidance as well.
Still, it bothered him—the jet so plainly contradicted his upbringing and self-image. He started to make fun of himself to the shareholders, saying, “I work cheap and travel expensive.”
The plane ushered in a new phase of his life. Buffett clung tenaciously to his corn belt—even while wearing black tie—yet fraternized ever more often with hoity-toity sosoity, as CEO of the Frozen Corporation. In 1987, Ambassador Walter Annenberg had invited Warren and Susie out to Palm Springs for a weekend with their friends Ronald and Nancy Reagan. Buffett had dined at the White House and already knew both the Reagans from visiting Kay Graham’s house on Martha’s Vineyard, but he had never spent a whole weekend with a sitting President. Nor had he ever played golf with one.
“Walter had his own private nine-hole golf course at Sunnylands. He had his own driving range with ten tees lined up and all these golf balls piled in perfect little neat pyramids. And there wasn’t anybody there. The course was immaculate. If he had four foursomes, Walter would say, ‘That’s too much play for my course,’ and send one of them off to play at Thunderbird Country Club. I’d go out there and hit four golf balls, and somebody’d run out and replace the pyramids. And that was the day at Sunnylands. It was as fancy as living gets.”
Annenberg paired Buffett that weekend with Reagan as a golf partner, so Secret Service agents trailed them—but refused to fetch golf balls out of water traps as Buffett had hoped.
Buffett had a mixed view of Reagan as President. He admired Reagan’s handling of geopolitics. However, under Reagan the United States went from being the world’s largest lender to its largest borrower. Just as junk bonds and leverage were ballooning on Wall Street, the government had been running up mountains of debt—which Buffett considered the Wimpy style of economics: I will gladly pay you Tuesday for a hamburger today.45 Buffett’s style was to own the cattle ranch—and he had the balance sheet to prove it.
Armored by Berkshire Hathaway’s balance sheet—and a golf scorecard signed by the President of the United States—Buffett was now a fortress of power. Every financial statistic pertaining to him and his company rang with exclamation points. Berkshire Hathaway’s book value per share had grown by more than twenty-three percent a year for twenty-three years! Buffett’s first group of partners had reaped $1.1 million for each $1,000 put into the partnership! Berkshire was trading at the dizzying price of $2,950 per share! Buffett himself had a net worth of $2.1 billion! A Wall Street money manager—an investor—was the ninth-richest man in the U.S.! Never had anyone climbed from the ranks of those who managed other people’s wealth to join the celebrated few on top of the feeding chain of riches. For the first time, the money from a partnership of investors had been used to grow an enormous business enterprise through a chess-game series of decisions to buy whole businesses as well as stocks. Inevitably, more people were going to call him for help.
The next person to pick up the phone was John Gutfreund, the man who ran Salomon Brothers and had endeared himself to Buffett by helping to save GEICO in 1976.
That he had done so showed both the strength and weakness of Salomon. The GEICO stock underwriting had been based on the opinion of one equity research analyst. If the firm had any stature in the marketplace of selling stocks, it would have passed on the deal as far too small to be worth the legal liability if it failed—as all the other firms had done. But Salomon, bold and decisive rather than bureaucratic, dared the risk because it needed the business. Buffett had always taken a liking to people who extended themselves and helped him make money. And Gutfreund’s reserved, intellectual prep-school personality, coupled with a domineering brutality, seems to have added to Buffett’s trust in him as overseer of an unruly-by-nature investment bank.
Gutfreund had grown up the son of a well-to-do meat-truck company owner in Scarsdale, New York, a golf-course-ringed suburb close to New York City. He’d majored in literature at Oberlin College, but was drawn to the trading floor by a golfing friend of his father’s, Billy Salomon, a descendant of one of the firm’s three founding brothers.
Salomon Brothers was born in 1910. Less than a decade later, the U.S. government became the tiny firm’s client by adding Salomon to its list of registered dealers of government securities. With this endorsement, Salomon, a game little terrier, scrapped its way to respectable size over the next three decades by sticking to its core business of trading bonds using its wits, nerve, and fidelity to clients.46 Meanwhile, dozens of other small brokers closed shop or were swallowed up by larger ones.
Joining a roomful of men who spent their days buying and selling bonds for clients on the phone, Gutfreund, like the rest, carved off a little slice of everything for Salomon in return for his labors. He proved a deft trader and made partner in 1963 at the age of thirty-four.
In 1978 Billy Salomon promoted Gutfreund to head of the firm, then retired. Three years later, Gutfreund showed up on his friend and mentor’s beachfront porch in East Hampton to say that he was selling Salomon to Phibro, a giant commodities dealer, to create Phibro-Salomon Inc. Gutfreund and his partners walked away with an average of nearly $8 million apiece in profit from the sale, while those who had built the firm and were now retired—like Billy Salomon—got zero, zilch.47 One former partner thought it a Greek tragedy: the story of Oedipus, who had killed his own father.
Gutfreund became co-CEO with Phibro’s David Tendler. Running a firm with a co-CEO is like trying to balance two ends of a seesaw in the air. When Phibro’s business slumped after the sale just as Salomon’s was soaring, Gutfreund wasted no time. He slammed his end of the seesaw to the ground and sent Tendler flying.
Gutfreund added a foreign-currency business, broadened into equity trading and underwriting, and expanded the bond business into Japan, Switzerland, and Germany. For the next few years, the witch doctors from academia with their computers and formulas filtered onto Wall Street, and Phibro-Salomon’s floor became populated with PhDs who unlocked the mathematical secrets of stripping, slicing, packaging, and trading mortgages. By inventing a whole new segment of the bond market, Salomon (for the Phibro-Salomon name never quite replaced “Solly” in people’s minds and was dumped in 1986) grew in a few short years from a second-tier firm to the top of the Street, with a swagger to match.
They ruled from “The Room,” Solly’s trading floor, a smoky palace about a third the size of an airplane hangar, filled with long double rows of desks where the traders, salespeople, and assistants crouched in front of banks of screens with a slice of pizza in one hand and a telephone receiver in the other. The daily battle took place as a symphony of groans and curses and farts and screams punctuating the background babble. Eccentrics were welcome, as long as they produced. Gutfreund walked the aisles glaring through horn-rimmed spectacles, chomping his stogie, and shredding screwups into piles of mulch on the trading floor.
The characters on the trading floor so dominated the bond-underwriting market that BusinessWeek crowned Salomon “The King of Wall Street.”48 The story also said it was the kind of place where the “long knives” could come out if things went south—in other words, that Gutfreund would purge anyone suspected of dissent in order to still a revolt.49
Salomon’s profits peaked in 1985, when the firm made $557 million after tax. But the new businesses—principally equities—didn’t earn their keep; thus, internal competition started to get out of hand. The star traders started to leave, enticed by million-dollar offers from other firms. Gutfreund ratcheted the pay upward to stem the tide. But he did not crack down on the new departments when they failed to produce, then came in with new five-year plans to fix their failures. His intimidating personality covered a soft underbelly: He shrank from hard decisions and substantive confrontations. As time passed, he spent less time in The Room and presided with a somewhat distracted air over a kingdom in which the threat of poison hung in the air. “My problem is that I am too deliberate on people issues,”50 he would later say. Somewhat unfairly, observers blamed not him but his wife, Susan.
Tied to her husband by a long, long leash, all through the 1980s Susan Gutfreund had raced headlong up Fifth Avenue, dragging the once-retiring CEO of Salomon behind her into international society. Gutfreund came to tolerate and even enjoy it because, he said, she expanded his horizons.
“It’s so expensive to be rich,” the former flight attendant complained—perhaps facetiously but nonetheless famously—to Malcolm Forbes.51 Susan’s party guests received chauffeur-delivered invitations tied with yellow roses for events that featured four types of caviar. She chilled her perfume in a refrigerator next to her bathtub. She yanked up her Chicago roots to become such a Francophile that her butler answered the phone in French. And she redid Salomon’s executive meeting room, drenching it with so much passementerie and ormolu that it “looked like a French bordello.”52 Thus did Susan Gutfreund become 1980s Nouvelle Society’s most beloved object of parody. Susan’s friends defended her, but nobody, not even her husband, denied that this outpouring of opulence had diverted his attention, at least a little bit.53
A corporate history published around this time included a telling remark. Instead of making a decision and expecting others to follow, it said Gutfreund “liked to involve the people who would be affected” and “would bend over backward to make them comfortable with what was to be done.” Nevertheless, wrote the author, protesting a bit too heartily, Gutfreund “is in ultimate control” and “his decisions after consultations are final.”54 In fact, some of Gutfreund’s former partners, now retitled “managing directors,” were mounting a major challenge to his authority. Having kept their commitment to grow, they now blamed him for the bloated costs and vied with one another for territory.
By the end of 1986, when earnings had begun to sink from the burden of the payroll—newly swollen by a forty percent staff increase—the managing directors nearly dethroned Gutfreund in a coup. The firm’s largest shareholder, the South African company Minorco, grew impatient and told Gutfreund it wanted to sell its block of stock. But when nothing happened and Salomon’s stock languished as the Dow rose forty-four percent, Minorco found its own buyer: Ron Perelman, the feared corporate raider who had taken over Revlon.
The executives did not want to work for Perelman and his designee.55 Gutfreund pushed the panic button and called Buffett, asking him to invest in Salomon as “white knight” to save Salomon from Perelman.56
Owning a company that sold vacuum cleaners was one thing. Even though Salomon was dominated by trading, which Buffett liked, the firm was muscling its way into investment banking and had belatedly caved to market pressure and set up a merchant banking business to finance takeovers using junk bonds, a technique he despised.
Yet Salomon’s expertise in reshaping the bond market appealed to Buffett at a time when good stock ideas had become scarce.57 While he denigrated junk bonds, he opportunistically arbitraged the takeovers that were done using them—shorting the stock of the acquirer and buying the stock of the acquiree. Since Salomon’s bond arbitrage unit made most of the firm’s profits, the firm in fact was an arbitrage machine, and he had a deep affinity and respect for this corner of Wall Street.
Moreover, Buffett’s nostrils had caught the rich warm scent of money, for Gutfreund had the air of desperation. So he said that Berkshire would buy $700 million of Salomon preferred stock, as long as it made fifteen percent.58 Gutfreund ordered his horrified employees to design a security that would deliver to Buffett the kind of returns normally earned only on a junk bond. Over the weekend of a Jewish holiday, when Gutfreund knew the observant Perelman would be neutralized, Buffett flew to New York, and he and Gutfreund met at Salomon’s lawyers’ offices. Buffett walked in by himself, without a briefcase or even a pad of paper in his hand. Over a handshake, he agreed to buy a preferred stock with a nine percent coupon that would convert to common stock at the price of $38.59
The nine percent yield gave Buffett a premium return until the stock went to $38, when he had the right to convert to equity. So the upside was unlimited. But if the stock went down, he had the right to “put” the security back to Salomon and get his money back.60 The deal worked out to an expected fifteen percent profit, on an investment that carried very little risk.61
Inside Salomon, people were outraged.62 For his huge fifteen percent return, Buffett was, as writer Michael Lewis would later explain, making “only the safe bet that Salomon would not go bankrupt.”63
What the firm had bought with all this money was Buffett’s reputation, which came partly at the expense of Gutfreund’s power. Along with the deal, Buffett and Munger each got board seats. Before signing the papers, Buffett climbed aboard his new jet and flew to New York. He met Munger at One New York Plaza to inspect Salomon.
Standing outside Gutfreund’s office next to the trading floor, he beheld The Room for the first time. Hundreds of disheveled people sweated in front of tiny green screens. Most had phones glued to each ear as they jostled, spat, puffed, and spun their way through multimillion-dollar deals. Curses and screams cut through the low roar that filled the air. Above the scene hung a hazy fog. So many traders calmed their nerves with tobacco, why bother to abstain? Everyone’s lungs were always filled with nicotine anyway.
Munger crossed his arms and turned to Buffett. “So, Warren,” he said. “You really want to invest in this, huh?”
Buffett stood, gazing out through the haze over the pandemonium that he was about to buy. “Mmmm-hmmmm,” he said, after a long pause.64
*A stock “split” carves a single share of stock into a certain number of pieces, each trading at the equivalent fraction of the former price.