Buffett’s Long-Term Gamble on Long-Term Capital

Rumor has it that Warren Buffett is back in the market for Long-Term Capital Management, the troubled hedge fund whose near-collapse was averted only by a Fed-orchestrated bailout. (That bailout was made necessary in the first place by Long-Term head John Meriwether’s rejection of a previous Buffett bid for the hedge fund, a rejection likely prompted both by the fire-sale price Buffett offered (somewhere around $250 million) and by the fact that Buffett wanted Meriwether to resign. (Somehow I suspect the latter consideration was probably pretty important.) The London Times reported today that Buffett is “planning” a bid for Long-Term, which now has $3.8 billion in assets backing up its positions.

The difference between $250 million and $3.8 billion seems considerable, but assuming Buffett bids less than $4 billion, the price would be effectively the same, since when Buffet made his initial bid Long-Term had only $200 million of capital left. For the 14 Wall Street firms that invested $3.6 billion to prop the hedge fund up, a Buffett buyout would allow them to emerge without any further scars from this debacle, and avoid any further worries over the eventual fate of Long-Term’s existing positions in markets around the world. Given the magnitude of the losses these firms have suffered in the last quarter, their appetite for risk has to be severely diminished. At this point, getting out of Long-Term with the money you invested feels almost like victory.

Why, then, would Buffett, who’s most famous for buying and holding stock in companies with unimpeachably strong market positions, be willing to put up $4 billion to buy Long-Term, whose entire trading strategy is predicated on price arbitrage? The obvious answer is: Because he thinks that the future value of Long-Term’s positions is much greater than its present value. The thing about Long-Term, after all, is that many of its bets were probably right. Eventually the spreads between corporate bonds and U.S. treasuries will narrow, and eventually money will flow back into emerging markets, driving down yields there, and some of Long-Term’s positions will become incredibly profitable. The problem was that Long-Term simply forgot about risk, and leveraged itself so heavily that it couldn’t keep enough money on hand to stay in the game. You can’t invest long-term without the capital to watch the world turn against you, and Long-Term’s name notwithstanding, it ended up without enough chips to keep betting.

Buffett, on the other hand, has literally more money than he knows what to do with. (This summer he said he “didn’t have many good ideas” about where to invest.) And he has the patience simply to wait until Long-Term’s positions eventually mature. (He can also divest himself of any positions that he doesn’t think will be winners in the long-term.) He doesn’t really have to worry about stockholders–as the Wall Street firms do–and he doesn’t have to worry about being able to unwind the positions if they continue to weaken in the short term. In most respects, then, this is the perfect purchase for Buffett to make.

More than that, it’s a mistake to think of Buffett as a conservative investor, at least if that implies that he’s intolerant of risk. Buffett has always engaged in arbitrage (he made huge sums of money on the RJR Nabisco deal), and he’s never shied away from investing in companies that appeared to be in trouble, if he believed that the market was excessively discounting their true value. It’s only in retrospect, after all, that Buffett’s shopping spree during the 1973-74 stock-market downturn looks like a sure thing. At the time, those investments would have appeared remarkably risky. What Buffett has always understood is that it’s over the long term that risk tends to give way to return. And he has the will to act accordingly even while everyone else is running for the doors.

Other Notes: Definitely check out the newest issue of Fortune for a hilarious story on the competition between Papa John’s and Pizza Hut and a really terrific piece by Peter Elkind on what really happened at Cendant, the company created by the ill-fated merger between HFS and CUC. The Cendant piece contains an incredible story about CUC controller Anne Pember telling a subordinate to “add pennies” to the fictitious revenue numbers that CUC invented to satisfy analysts, since if the numbers were round they’d be less believable. It’s almost too good to be true.

On a very different note, you should pick up Rick Bass’s new book The New Wolves (Lyons Press), an account of the reintroduction, as a result of the Endangered Species Act, of the Mexican wolf into the American Southwest. I’m a sucker for wolves, so of course I loved this, but Bass’ book is more than just an evocative story about the struggle to make the Mexican wolf a viable species outside captivity. It’s also a sophisticated portrait of the economic issues at stake in the struggle over conservation policy and Western ranching. The reintroduction of the wolf cannot be separated from federal policy that leases land to ranchers at a fifth of fair market value, or from the environmental costs inflicted by cattle-raising, costs that are for the most part not included in the price of a steak. Bass is a meat eater and a hunter, and offers no simplistic solutions here and no facile condemnations of ranchers. What he offers instead is yet another illustration of that most important lesson of economics: there are no free lunches. Whether the costs are hidden or not, we pay for the choices we make.