There’s a lot of talk about how the bailouts are creating moral hazard and rewarding bad behaviour. But those are pretty abstract ideas, the kind of things people wonder whether or not we can afford to worry about while the economy is tanking. Sure we’ll pay a long run price for screwing up the market’s discipline but in the long run we’re all dead.
So forget “moral hazard” and just look at Warren Buffett’s description of what is happening to his home construction business, Clayton Homes. Clayton, which makes pre-fab homes, also has a lending business. Surprisingly, Clayton hasn’t been crushed by the markets because it maintained high lending standards and doesn’t have a balance sheet overflowing with defaulting loans.
But it is getting crushed anyway. But the crushing agent is the government not the markets. You see, the government has extended loan guarantees of various sorts to troubled financial companies. This means that a bank or a financial company able to borrow under a government backed facility will be able to raise capital at low prices. Clayton gets crowded out of the market as would-be lenders flock to the safety of the government backed facilities. What’s more, Clayton must then attempt to compete with these borrowers despite it’s higher borrowing costs.
Here’s the news from Buffett’s letter:
Clayton’s lending operations, though not damaged by the performance of its borrowers is nevertheless threatened by an element of the credit crisis. Funders that have access to any sort of government guarantee — banks with FDIC-insured deposits, large entities with commercial paper backed by the Federal Reserve, and others who are using imaginitive methods (or lobbying skills) to come under the government’s umbrella — have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower, but often scarce for others no matter how creditworthy they are.
This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with favoured status. Government is determining the “haves” and the “have nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.
Though Berkshire’s credit rating 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. At the moment it is far better to be a financial cripple with a government guarantee than a Gibraltar without one.
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