Warren Buffett is a margin of safety investor. That is, Buffet purchases equity stakes in companies only when he is more or less certain that he won’t permanently lose his capital and where the price is such that he believes he will earn an outstanding return on his investment over time. In order to practice this risk averse method of investing, Buffett has often had to pass on investment opportunities where it was not clear to him how the competitive dynamics of the relevant industry would change over time.

During the tech bubble of the 90s, for example, Buffett was derided as being a stodgy old man who simply did not understand the new era of business. However, while Buffett did pass on some outstanding opportunities, he did so because it was difficult for him to predict how these “tech” companies would reinvest capital into their businesses in a way that would maintain or grow their earnings such that the prices quoted for their shares provided a margin of safety. Buffett also knew that the “moats” of many of these companies could easily be crossed by new entrants selling the latest and greatest disruptive technologies and so he declined to participate across the board. This led to a general theory among the press that Buffett simply would not invest in tech companies because he did not understand how these companies worked.

So many Buffett followers were perplexed when he saw fit to buy close to 10% of BYD Company Limited (BYD), a Chinese manufacturer of rechargeable batteries, mobile handset components, and cars, in October of last year. The purchase was largely viewed in the media as a bet on BYD’s batteries playing a large part in the future of personal transport, either through the sale of its batteries to car manufacturers or through the sale of its own cars. The purchase was also cast as an atypical investment for Buffett, since the company was trying to bring to market a new disruptive technology – namely, a low priced, all-electric vehicle. However, when one digs deeper into the investment, one begins to realize that the investment is vintage Buffett and will, in fact, probably turn out to be one of the best investments that Buffett ever makes in his lifetime. Berkshire’s stake in BYD not only has the adequate margin of safety required by Buffett but also represents the future of Berkshire. Buffett and his partner in crime Charlie Munger are beginning to position Berkshire for what they believe will be the “Chinese Century.”

BYD deals with two businesses: IT manufacturing and auto manufacturing. It has production bases in several large Chinese manufacturing centers as well as in Japan, Korea, Taiwan and various emerging markets (such as Hungary and India). It is a public company and is listed on both the Chinese and Hong Kong stock exchanges. According to a Harvard Business School case study on BYD (required reading, in my opinion, if you really wish to understand Buffett’s interest in the company), the company opened up shop in 1995 and by 2002 became the world’s second largest manufacturer of rechargeable batteries. This was considered a remarkable feat because battery manufacturing was traditionally viewed as a capital intensive business that required large expenditures on things like robotic arms and dry rooms. Chinese companies’ comparative advantage was always thought to be their access to a large supply of cheap labor and so it was assumed that no Chinese company would be able to compete in the battery business. However, BYD was able to become a low cost producer of rechargeable batteries by changing the manufacturing process such that labor became a much larger input and capital equipment became a much smaller input.

BYD also had a one-up on most other Chinese manufacturing companies because it spent far more money on R&D focused on both product improvement and, more importantly, on manufacturing process improvement. This focus on both product and production process engineering is what enabled BYD to become the second largest rechargeable battery supplier in the world so quickly, as the company was able to manufacture batteries in a way that maintained quality control even while relying heavily on human resources for its manufacturing lines. It has also enabled the company to jump into other manufacturing businesses and become the low cost producer over time, as with its entry into mobile handset production. And while turnover on the assembly line side of the business is fairly high, turnover on the intellectual resources side of the business (R&D scientists) is quite low. BYD has been able to keep people on board by offering great benefits, including free housing, food, health insurance, access to free education for their children, and the opportunity to interact socially through athletic events, art programs, etc. In other words, BYD offers its employees Google-like benefits in order to keep them happy and working hard. This is just one of the reasons why BYD has been able to recruit from the “‘top of the top’” in China and why BYD will continue to innovate going forward.

Charlie Munger has called Wang Chuan-Fu a combination of Thomas Edison and Jack Welch, but I believe a more apt comparison for Wang Chuan-Fu is with the titan of American business Henry Ford. Like Ford, Wang started out as a skilled engineer and scientist who actually helped create and design new technological innovations (even working at the Edison Illuminating Company at one point). Like Ford, Wang eventually became a successful entrepreneur that excelled not only in creating innovative and value enhancing products, but also in coming up with new ways to optimize the manufacturing process in a way that made his company a low cost producer. Like Ford, Wang has vertically integrated his company so that it has become a one-stop shop for equipment manufacturing, thus capturing the entire value associated with the manufacturing supply chain. And like Ford, Wang has recognized that it is important for his workers – his human resources – to be taken care of both so that they will be more productive and stay at the company, but also because it is important that they themselves be able to buy the products they are manufacturing. Would you buy into a company run by the Chinese Henry Ford given the chance? I would.

By investing in BYD, Buffett has achieved several amazing feats at once. First, he has bought into a company that could potentially be the lowest cost manufacturer of a number of complex goods, not just batteries, handsets, and cars. BYD initially started out in batteries but then expanded into handsets, LCD screens, and automobiles, and it has always been able to generate profits in these growth enterprises by becoming a low cost manufacturer. BYD’s moat, it seems, comes from the company’s incredible ability to tailor the manufacturing process of complex goods in a way that takes advantage of China’s labor supply advantage. Additionally, BYD has done a good job of fending off competitors by vertically integrating the supply chain, thereby controlling the cost and quality of production and protecting its intellectual property and know-how. According to Wang Chuan-Fu, China is a ruthless place in terms of business competition, and its commercial law is relatively underdeveloped and under-enforced, so it is important that companies adapt their business models to deal with this reality. Learning how business works in China will be much easier with Wang Chuan-Fu at Buffett’s disposal.

Second, by investing in BYD Berkshire has gained access to the largest potential market for goods and services in the world. The growth of China in the coming years will be tremendous, and it is likely that the Chinese will be clamoring for products and service from home and abroad. Mobile phones, LCD TVs, and automobiles are all growth areas where the Chinese can supply themselves if they wish (through companies like BYD), but there are areas where the Chinese will want to purchase from foreigners or open up their markets to foreign investors. For example, the rapid industrialization of China will require huge amounts of electricity, and the Chinese would probably love to work with American utility companies who have expertise in supplying electricity using various types of generating technologies in a way that reduces pollutants and CO2 emissions. This presents a perfect opportunity for MidAmerican, the Berkshire utility subsidiary that made the strategic acquisition of shares in BYD. One can also imagine that the Chinese will increasingly see the social benefits of a robust and healthy private insurance market. By getting a toehold in the Chinese market, making business and political connections there, and learning more about the various risks of doing business in China, Berkshire may eventually be able to provide insurance capacity in China in the manner that it does in the U.S. This will give Chinese citizens access to insurance policies from a company that will always be able to make good on its promises due to its responsible underwriting and healthy investment practices.

Third, Buffet’s investment in BYD will better enable Berkshire to access one of the largest pools of talent in the world. China is continually churning out loads of intellectual talent, particularly in the fields of natural science, engineering, and business, and BYD is a top repository of such talent. Berkshire will be able to access China’s top talent both directly through BYD and through the networks of the individuals working for BYD, including Wang Chuan-Fu, thus allowing Berkshire to be more “linked in” to the Chinese business, scientific, and political communities. This in turn will enable Buffett and his successors to capitalize on new technologies that emerge from Chinese industry and to better understand the business climate in China as it changes. For example, if MidAmerican is deciding on investing in battery storage for its renewable energy portfolio, it can turn to BYD for advice on the appropriate technologies or even be directed by BYD to the companies BYD believes has the best technology for MidAmerican’s purposes. Or if Berkshire is interested in being involved in the development of traditional or renewable generation capacity in China, it can tap into BYD’s talent network to figure out what the regulatory outlook is like in China for allowing foreign investment in utilities.

Finally, given BYD’s growth potential, Berkshire has purchased its stake in BYD for what appears to be an outstanding price. Take a look at BYD’s annual report for 2008. Buffett infused about HK$ 1.8 billion worth of capital into BYD for a purchase price of HK$ 8 per share, resulting in a 10% stake in BYD. Last year, BYD earned RMB 0.50 per share, which is currently equivalent to about HK$ 0.57. Assuming that reported earnings are a good approximation of “owner earnings” and that BYD’s owner earnings will merely be maintained over the business’ lifetime, Buffet’s earnings yield for his stake is close to 7%. This is an excellent price for a company that in actuality has huge growth potential, especially when you consider that much of BYD’s income generating assets are intangible in nature (remember: its production process know-how is what helps it to be the low cost manufacturer).

BYD has a legitimate shot at becoming one of the largest suppliers of electric vehicle-related battery technology in the world given its low cost battery manufacturing capabilities. Furthermore, it is possible – though not necessarily probable – that BYD will become the largest automaker in the world. If BYD succeeds in this respect, it will probably be because its cars present a value proposition for emerging market customers rather than its cars being of the best quality. Regardless, BYD will almost certainly become a major auto manufacturer in China if the government subsidizes the purchase of all-electric vehicles. One must also remember that the Japanese were initially derided for manufacturing low quality electronics and vehicles, but now they are fierce competitors that are known for their manufacturing prowess across the globe. Just imagine if BYD is able to start generating valuable intellectual property related to its products in addition to its production processes. Could BYD become the new Sony or the new Toyota? It’s possible, and Buffett has essentially gotten this option value on BYD’s success for free.

Buffett and Munger believe that while the twentieth century was the American Century, the twenty-first will be the Chinese Century. Thus, the BYD investment should be viewed as Berkshire’s stepping stone into China. Those who deride Buffett for having a subpar record over the last decade should take note: if Buffett continues to make investments in companies like BYD, Berkshire will easily outperform the U.S. stock market for years to come.

Disclosure: Please note that the author currently owns shares in Berkshire Hathaway (BRK.B).

Last week, Treasury Secretary Timothy Geithner finally released more details about the government’s plan to fix the credit markets. The plan, it seems, involves the creation of funds to buy troubled assets from banks that will be backed by public and private sector equity and financed by the public sector. These funds will be allowed to lever up so that the relevant bank assets will be purchased at prices well above what they are currently trading for in the markets.

Detractors immediately panned the plan, claiming that it was merely a subsidy to hedge funds and other Wall Street denizens who helped cause the crisis in the first place. Buying the troubled assets would do nothing to help spur bank lending, and Geithner, they argued, appeared to have been captured by Wall Street. In attacking the government’s plan, many of these detractors continued to indiscriminately throw out terms like “insolvency” and “toxic assets” to give the impression that the majority of the big commercial banks were doomed to either fail or become so-called “zombie banks.” These commentators also ably ridiculed Treasury for its pitiful attempt to rebrand the loans and asset-backed securities on the banks’ books as “legacy loans” and “legacy securities,” terms that sound like government doublespeak designed to confuse or deceive the public.

The government has received no credit for what appears to be steps in the right direction to get the credit markets functioning again, with the proposed plan hopefully freeing up bank capital for new loan issuances and restarting the securitization markets. The problem is that the administration has failed to communicate with the public about the plan in an understandable way and has even dodged important issues that must be clarified in order to inspire confidence that the government is doing the right thing. Critics like Paul Krugman and Nouriel Roubini have made superficially compelling arguments that, while having genuine substance behind them, have not been presented to the public in a substantive manner, and the government has made no real rejoinders to these arguments. The risk is that this failure to communicate will result in a lack of political will necessary to pull the economy out of recession.

The administration seems to be aware of this communications problem. On Sunday, Secretary Geithner appeared on “Meet the Press” and “This Nation” to explain the government’s rationale behind its plan. Geithner explained the importance of the credit markets to the economy and the necessity of unfreezing them in order to maintain any chance whatsoever of climbing out of this recession. He pointed out that, until recently, close to half of the lending capacity in our economy was provided by non-bank lenders and so it was very important to restart the securitization market and have new bond issuances. Most importantly, Geithner indicated – somewhat obliquely – that the government’s Public-Private Investment Program (PPIP) was designed to take assets off the balance sheets of banks not to save them all from failing due to insolvency but rather to free up capital to enable banks to originate new, productive loans (and lines of credit) and to make it easier to put money into banks that need to be recapitalized. In other words, the new program will help the government and private sector recapitalize banks that fail the government’s stress tests in a more surgical manner and will also help restart the securitization markets at the same time.

While Geithner’s appearance on the Sunday morning news circuit was a good start, it is not at all sufficient for making people understand the importance of the new program. Geithner, though clearly a smart and devoted public servant, simply does not have the teaching skills or charisma needed to present what we’re facing in a way that most citizens will understand, and unfortunately, he also lacks credibility in that he is considered by many (wrongly, in my opinion) to be a regulator who has been captured by Wall Street. Thus, it is imperative that President Obama himself take the time to explain what has happened to the financial system thus far and what the government is doing about it, perhaps using visuals and the new communications technologies it is said he is so fond of.

When President Obama talks to the nation about the financial crisis, he must address several of the issues that critics have raised against the government’s plans in a genuine and non-evasive manner. The most important of these issues are: (1) the solvency of the banking system; (2) the unintended consequences of nationalization as an alternative solution; and (3) the rationale behind creating funds where private investors share in both the upside and downside risk of purchasing troubled assets.

The Solvency of the Banking System. Paul Krugman and Nouriel Roubini suggest that if a bank is “insolvent,” it will either fail or refuse to lend in an appropriate manner. Though there is substance behind their argument, this substance has not really been presented to the public, and most reporters and commentators merely cite Krugman and Roubini for the proposition that “insolvency” equals “bank failure” or “zombie bank.” The administration must add nuance to the policy debate by explaining the relevance of bank insolvency and by detailing the government’s plans to mitigate the detrimental effects that bank insolvency might be having on the extension of credit.

The government must show that it is not so much a question of whether a bank is technically insolvent – where the bank’s tangible assets are determined to be less than its liabilities – but whether the bank’s balance sheet is so impaired that it will refuse to lend in order to maintain capital adequacy ratios or to prop up related non-bank affiliate companies. Consider this: if a bank is truly insolvent, the best way for the bank to climb out of the hole in an environment with very low interest rates is to borrow more money or take in more deposits and lend this money at relatively high interest rates. Why, then, would the banks hoard money rather than lend it out? There are only two reasons I can think of.

One is that banks are afraid that if their troubled assets are required to be marked down any further, they will have to keep cash in the bank to remain adequately capitalized as per regulatory requirements or face having to shop for cash infusions. In this market environment, many companies (not just banks) have only been able to raise cash by borrowing money at punitive interest rates (think about the preferred deal that Buffett struck with Goldman) or by raising equity at extremely depressed market prices, which has severely diluted existing shareholders’ stakes. This is why banks lobbied for and successfully obtained a relaxation of the mark-to-market accounting rules. The theory goes that if banks are not forced to mark down their troubled assets to market values, they will not have to raise money to stay adequately capitalized and so they will be more than willing to lend out what cash they do have in order to climb out of insolvency.

The second reason why banks may be hoarding capital is that banks controlled by financial conglomerates like Citigroup and the ilk may be using bank capital to shore up their more troubled affiliate companies. For example, the Citibank subsidiary of Citigroup is probably adequately capitalized at this time, but the other non-banking subsidiaries of Citigroup – say, the division that wrote credit default swaps – could very well be bleeding money right now. This hemorrhaging of capital could potentially result in liquidity issues that would force the holding company into bankruptcy court. Thus, before the government got involved with Citigroup, the holding company was incentivized to take bank capital and profits and send it over to its more troubled subsidiaries rather than using that money to issue new loans. This focus on shoring up non-banking subsidiaries would also explain why there have been recent reports indicating that the big financial conglomerates are interested in participating in the PPIP, which could result in the non-banking subsidiaries earning juicy profits in the short term.

The ultimate takeaway is that the government has decided to take the time to make qualitative decisions about which banks are likely to act badly rather than just nationalizing them all. This is not that unusual. After all, the FDIC takes into account several factors when deciding whether a bank should be put into receivership, including risk management controls, profitability of operations, quality of assets on the books, capital levels, and the bank’s ability to meet obligations such as withdrawals by depositors, rental payments, and labor costs (i.e., the bank’s liquidity). However, in order for the government and private investors to determine how much capital the banking system really needs, the government must remove the troubled assets that are clouding everyone’s view of how much money will be necessary. Once these assets are removed, the government will “stress test” the banks in a way that will prevent the banks from using their capital for unhelpful purposes such as paying dividends and that will help the government and the private sector recapitalize the banks in a manner that will be least costly to the taxpayers.

But before the government can proceed, it will need to make this case to the public in a way that will get most of Congress behind the plan.

The Unintended Consequences of Nationalization. Krugman and Roubini disagree with the government’s approach to recapitalizing the banking sector and believe that using the blunt instrument of nationalization is the only way to solve the problem of banks that refuse to lend. When Secretary Geithner appeared on Meet the Press, he didn’t address the issue of nationalization, either with respect to FDIC takeovers of banks or the effective nationalization of financial services conglomerates through 80% government ownership. On the contrary, he quite misleadingly presented the choice the government faces as binary, with the government buying troubled assets from the public sector either by itself or with the help of private investors.

President Obama must explain why the government has taken the nationalization solution off the table with respect to the big banks. Nationalizing the bank and financial holding companies will probably cost the government much more money than the proposed program. One of the lessons learned from the AIG debacle is that the government won’t be able to easily sell off the assets or subsidiaries of complex financial organizations that have been nationalized. While the government searches for buyers, the taxpayers will have to pay the cost of running these companies while at the same time watching the value of these companies diminish due to the stigma of government ownership and the corrosive way in which politicians will use public outrage to their own benefit. If the government does find private buyers for the subsidiaries of the big banks, these buyers will demand that the taxpayers sell these off at fire sale prices since there will be so many more attractive investments available to the potential buyers.

It is also likely that the equity and credit markets will go haywire once again in the event of large scale nationalizations. The government needs private capital to participate in the recapitalization of the banking system, and there is no guarantee that private capital will be able to raise funds to purchase financial assets if the government crosses that line. Like it or not, the performance of the equity and credit markets matter when it comes to raising capital from investors.

The government has a hammer in its tool belt called nationalization. The problem is that many commentators are claiming that everything in the financial system looks like a nail.

The Use of Private Investors to Purchase Troubled Assets. The President must also explain to the public why the government has chosen to recruit private capital for the purchase of troubled assets from the bank. Secretary Geithner stated on Sunday that the government wishes to use the expertise of private investors determine the appropriate price to pay for banks’ assets so that taxpayers will not overpay for these assets. This makes perfect sense since it will take lots of legwork to value these assets given their complexity, and the government simply does not have the workforce required to undertake this task.

But Secretary Geithner did not adequately address the criticisms leveled at the plan by commentators like Krugman who claim that this is merely a subsidy to private investors who will naturally overpay for the assets they make bids on given the use of leverage. This is perhaps one of the most foolish criticisms of the plan, as it completely ignores investors’ aversion to downside risk. Leverage always amplifies the results of an investment decision. Low returns on an unleveraged basis can be transformed into very high returns when leverage is used. However, losses can also be amplified with leverage, and no investor in their right mind would be willing to risk the complete loss of their capital by making the expected value calculations that Krugman does, particularly in an environment where almost everyone has lost a great deal of money on their investments.

Note that it is highly unlikely that the troubled assets to be purchased will be worth nothing, and if the private investors walk away from the government loans because the assets are worth less than what they paid, it will be because their equity has been wiped out. This is not unlike the homeowner who walks away from an underwater mortgage, thereby losing all of his down payment, the interest he paid, and the house. Investors concerned with downside risk are incentivized to purchase these assets at prices that will allow for a margin of safety for their equity. It is true that the asset managers who will be running these funds might be willing to bet the farm if their fees are bumped up for outsized performance with no regards to risk, but the government will almost certainly structure the funds in a way that will not incentivize this type of bad behavior.

How to Communicate These Issues to the Public. Geithner’s appearances on Sunday were a good start for communicating with the public about the government’s plans to fix the financial system, but his failure to address certain issues has continued to give fodder to the administration’s critics and to members of Congress who wish to exploit the deep antipathy (rightly deserved) that the public has towards Wall Street at this time. Citizens are getting angrier and angrier about government action that they perceive as at best ill-conceived and at worst corrupt. And they simply don’t trust that the Treasury or the government, in general, is being honest with them about what’s really going on behind the scenes. When the time comes for the administration to ask for more money from Congress to recapitalize banks that have failed the stress test, if the citizens are not on the administration’s side, Congress may very well take actions that result in a far worse economic situation than could otherwise have been.

This is why the President himself must expend some political capital to get the people on the side of the government. The President currently enjoys outstanding approval ratings that indicate that the American people trust him far more than they do the rest of the government. This is primarily because everything he has said about the financial crisis has been in the form of platitudes and hopeful rhetoric. All the substance of the government’s plans has been released through channels that simply don’t get the attention of most Americans. Op-eds written by unknown government officials in the Wall Street Journal, appearances on news shows by these officials, press releases, and the creation of new websites such as financialstability.gov just won’t cut it.

President Obama himself must give the country a true fireside chat on the topic of the banks, just as FDR did over 75 years ago. Because the problems with the financial system are so much more complex now, the President will have to take the time to figure out the way to best present the government’s views to the people, and he must do this in an honest and non-partisan manner. Whether President Obama will use his pulpit to counter criticisms of the government’s plan will not only be a test of this administration’s willingness to do what it takes to ensure economic recovery, but also a test of the government’s willingness to communicate and be transparent with the citizens of this country.

Distressed equity securities are usually too difficult for most ordinary investors to handle, and the majority of outside passive minority investors would be well-advised to stay clear of such companies unless they are extremely confident that they will not lose their principal in the case of bankruptcy, run-off, or, in times like these, receivership or nationalization.  Deep-pocketed outside investors or control investors, on the other hand, enjoy quite a different position than ordinary investors, as they can try to influence a distressed company’s restructuring process, implement turn around plans, invest new capital into the company, or in some cases acquire the troubled company at an extremely low price.

Warren Buffett has often stated that he tries to purchase great businesses trading at fair prices, but Buffett, unlike many investors, also often has the opportunity to acquire distressed companies that could be great businesses under different circumstances, and that are trading at great prices.  Last year, for example, Berkshire’s MidAmerican Energy subsidiary made a bid for Constellation Energy that was so low it would have effectively been stealing the company had another bidder not appeared.  Buffett was able to make such a lowball bid because Constellation had severe liquidity issues, and Berkshire was offering Constellation an immediate cash infusion that would have enabled the company to avoid filing for bankruptcy protection.

Deep-pocketed value investors such as Bruce Berkowitz’s Fairholme Fund and Leucadia National, the conglomerate run by Ian Cummings and Joseph Steinberg, are at their best when they are able to find distressed investment opportunities like the ones Buffett enjoys.  Fairholme and Leucadia have found just such an opportunity in their investment in AmeriCredit, an auto finance company that operates primarily in the subprime space.  To understand what they see in AmeriCredit, it is important to recognize that Berkowitz, Cummings, and Steinberg – some of the shrewdest investors out there – are huge Buffett admirers and have probably learned a great deal from closely following his deal making.  Indeed, their investment in AmeriCredit has many similarities to Buffett’s acquisition of a manufactured housing company called Clayton Homes in 2003, which Buffett discussed at length in this year’s annual letter to the shareholders of Berkshire Hathaway.  It would be instructive to discuss Buffett’s acquisition of Clayton Homes to understand the opportunity Fairholme and Leucadia see in AmeriCredit and also to learn some useful lessons about subprime lending and securitization along the way.

Clayton Homes is the largest company in the manufactured home industry and, according to Buffett, is responsible for about 34% of the industry’s total sales.  In addition to being a manufacturer, Clayton also finances the majority of sales made to its homebuyers.  In 2003, Berkshire was able to buy Clayton Homes at a steep discount to the company’s intrinsic value by taking advantage of industry-wide distress, Berkshire’s AAA balance sheet, and Jim Clayton’s affinity for Warren Buffett.

Here’s Buffett discussing the Clayton Homes acquisition and the distressed state of the manufactured housing industry back in his 2003 annual letter:

Progress in design and construction [in the manufactured housing industry] was not matched [] by progress in distribution and financing.  Instead, as the years went by, the industry’s business model increasingly centered on the ability of both the retailer and manufacturer to unload terrible loans on naive lenders.  When “securitization” then became popular in the 1990s, further distancing the supplier of funds from the lending transaction, the industry’s conduct went from bad to worse.  Much of its volume a few years back came from buyers who shouldn’t have bought, financed by lenders who shouldn’t have lent.  The consequence has been huge numbers of repossessions and pitifully low recoveries on the units repossessed.

. . . Clayton, though it could not isolate itself from industry practices, behaved considerably better than its major competitors.

* * *

[When I made an offer for the business,] Clayton’s board was receptive, since it understood that the large-scale financing Clayton would need in the future might be hard to get.  Lenders had fled the industry and securitizations, when possible at all, carried far more expensive and restrictive terms than was previously the case.  This tightening was particularly serious for Clayton, whose earnings significantly depended on securitizations.

Today, the manufactured housing industry remains awash in problems. Delinquencies continue high, repossessed units still abound and the number of retailers has been halved.  A different business model is required, one that eliminates the ability of the retailer and salesman to pocket substantial money up front by making sales financed by loans that are destined to default.

Sound familiar?  Buffett thinks so.  In his 2008 letter he states that the “manufactured-home debacle,” which resulted in “staggering industry losses,” “should have served as a canary-in-the-coal-mine warning for the far-larger conventional housing market” that precipitated the financial meltdown last year.

So why did Buffett buy a manufacturer in an industry where demand was declining, where sales were dependent on providing loans to borrowers with low FICO scores (many of whom were “subprime” borrowers), and where the ability to fund such loans required accessing a securitization market that increasingly refused to participate in such lending?  Because he saw value in acquiring a distressed company such as Clayton that manufactured a decent product and made good lending decisions to buyers of its products.  Buffett knew that as a subsidiary of Berkshire, Clayton Homes’ funding problems would disappear.  The company could then concentrate on making appropriately priced mortgage loans to manufactured home buyers and taking market share away from its competitors who were dependent upon a faltering securitization market that no longer trusted manufactured home loan originators.

As of yearend, the delinquency rate on loans originated by Clayton was only at 3.6% despite so many of these loans being “subprime.”  Buffett explains the low delinquency rate by praising borrowers’ virtuous decisions, stating that Clayton’s borrowers “took out a mortgage with the intention of paying it off, whatever the course of home prices.”  In reality, it is Clayton Homes’ management that should be praised for their insistence on properly conducted due diligence and adherence to conservative underwriting standards.  According to its last 10-K filed with the SEC before the acquisition, Clayton’s underwriting guidelines “require that each applicant’s credit, residence, employment  history  and  income  to  debt  payment  ratios  meet  predetermined guidelines.”

In other words, Clayton Homes practices risk management, something that the majority of financiers apparently forgot about (or didn’t care about) in the past years of cheap credit.  Clayton makes sure that its borrowers – including so-called “subprime” borrowers – have enough income to be able to make their monthly mortgage payments.  As Buffett points out in his annual letter, foreclosures are usually event-driven. That is, they occur as a result of job loss, death, medical problems, etc.  After all, buying a primary residence is not just an act of investment – it’s an act of consumption.  It shouldn’t matter if a mortgage is “underwater” so long as the buyer is happy with the value he’s gotten and can afford to make payments on the home.  Lenders who originate well-priced, reasonably structured loans to borrowers who are intent on utilizing their homes should, over time, earn a return on the total portfolio of loans underwritten even if the lender does not intend to sell the loans to third parties.

Today, we are seeing turmoil in the asset-backed securities market on a much larger scale than ever before, and lenders of all types who have relied on the securitization market to permanently finance their loan originations are in danger of losing their status as going concerns.  AmeriCredit is one such company that, despite having admirable underwriting standards and due diligence practices, is facing the possibility of going into run-off due to its reliance on securitization.

AmeriCredit purchases new and used car installment sales contracts originated by automobile dealers in its dealership network, the majority of which are for cars purchased by subprime borrowers.  AmeriCredit then securitizes these auto finance receivables, earning income from the difference between the finance charges received and the interest paid to investors in the asset-backed securities.  Because the securitization transactions are structured as secured financings, the finance receivables and the related securitization notes payable remain on AmeriCredit’s balance sheet.

Like Clayton Homes before the acquisition by Berkshire, AmeriCredit funds its originations in the short term by drawing down its warehouse lines of credit and in the long term by securitizing the finance receivables it has purchased.  And like Clayton before the acquisition, AmeriCredit’s earnings depend significantly on a functioning securitization market.  Here’s Bruce Berkowitz discussing AmeriCredit’s problems in an interview with Forbes:

They got caught up in the shutting down of the securitization market, which is a tough business.  At the end of the day, if you are dependent on securitizations and nobody can securitize for you anymore, it can be a death blow.  But with AmeriCredit, they did it the right way.  They give loans to people that need cars to get to work.  They do the loans based upon the income of the person, not the collateral value of the car.  They do their own work as to whether or not the person can afford the car.  They don’t want to sell the car to someone who can’t afford it, unlike a dealer that just wants to sell the car, get the commission and thank you very much.  So they do the work and the management is smart.

This description of AmeriCredit’s operations explains why Fairholme and Leucadia collectively own close to 50% of the common shares of AmeriCredit, as they appear to have identified an opportunity incredibly similar to the one that Warren Buffett saw in 2003.

In the worst case scenario, Fairholme and Leucadia probably won’t lose any money.  Berkowitz has indicated in interviews that he has identified the present value of the inflows and outflows in the case of run-off and has determined that there is a margin of safety in the price Fairholme has paid for its shares.  Berkowitz’s judgment that AmeriCredit’s current book value probably represents its liquidation value is trustworthy not only because he is a phenomenal investor but also because the company appears to have acted appropriately in marking down its loan book as the economy has deteriorated and defaults have increased.  It’s also important to recognize that AmeriCredit’s annualized net credit loss ratio is currently only around 9%, and while it is likely this ratio will go up, it is unlikely that it will skyrocket upwards due to borrowers walking away from their cars.  After all, AmeriCredit’s borrowers have purchased vehicles that they know will depreciate in market value because they need these vehicles to get to and from work.  As with Clayton Homes’ borrowers, defaults and repossessions for AmeriCredit’s borrowers tend to be event-driven, and the company does its best to work with borrowers to maximize the amounts ultimately recovered from the loans.

In the best case scenario – where the securitization market recovers and AmeriCredit avoids run-off – the investment will be a home run, probably even better than Buffett’s acquisition of Clayton Homes.  Unless a robust public transportation system or ubiquitous car sharing industry suddenly appears overnight in the United States, individuals with below prime credit scores will need to obtain loans to purchase cars for getting to work for the foreseeable future.  AmeriCredit has been serving such individuals for years now, and unlike many other lenders, the company has been doing it the right way.

AmeriCredit is incentivized to make sure that the dealers it does business with lend money in a responsible fashion because all loans purchased are kept on the company’s balance sheet even after they have been transferred into a securitization trust.  This method of securitization – where the securitizing party retains equity in the loans securitized – ensures buyers of AmeriCredit’s asset-backed securities that the loans are not destined to default because if defaults do occur, the company itself takes a hit.  It would not at all be surprising if investors demand this sort of structure for asset-backed securities going forward, since so many of them have been burned by irresponsible lenders who were only interested in selling off as many loans as possible regardless of the risk of credit losses.  If AmeriCredit can overcome its liquidity issues and the securitization market recovers in a timely fashion, the company will be well-positioned to substantially increase its share of the subprime auto loan market, and the company will be worth far more than its current market capitalization.

How likely is it that AmeriCredit will avoid run-off?  It’s probably quite likely given management’s actions and the involvement of Fairholme and Leucadia.  AmeriCredit dodged a bullet in December by successfully issuing $1 billion of senior/subordinated securitization notes, which will enable them to operate without needing to access the securitization market until late 2009.  They were able to complete the securitization transaction because Fairholme agreed to purchase the subordinated bonds as part of an exchange of senior notes held by Fairholme for newly issued AmeriCredit common.  This transaction increased Fairholme’s stake in AmeriCredit to 24.6% of the company, which means that AmeriCredit now has two institutions, Fairholme and Leucadia, which will do everything in their power to make sure that the company remains a going concern.

Then, earlier this month AmeriCredit dodged another bullet by successfully obtaining the amendment and extension of its short term loan facility.  Before the amendments were granted, certain covenants associated with AmeriCredit’s warehouse credit facility would almost certainly have been breached by the company, including a covenant requiring that the its net credit loss ratio not go over 8.5% on a rolling six-month annualized basis.  This would have put AmeriCredit in default, and the company could have had all its short term funding for originations cut off.  Having no access to short term funding would have resulted in the company’s going into run-off.  However, the warehouse lenders agreed to modify the credit facility by amending the covenants at issue, reducing the size of the facility, and increasing the cost of funds to better match the current credit environment.  This was both a win for the lenders and for AmeriCredit.

Given the above developments, it is likely that the company’s liquidity issues will probably be resolved once the Fed’s Term Asset-Backed Securities Loan Facility (TALF) gets up and running.  The TALF will hopefully help restart the securitization market so that investors are willing to purchase asset-backed securities issued by honest and competent lenders such as AmeriCredit.  AmeriCredit estimates that about 70–75% of its new senior-subordinated securities will be AAA-rated, which means that these securities will be eligible investments for TALF participants.  However, AmeriCredit also notes that in order to find buyers for its subordinated AA- and A-rated securities, the company may have to pay investors “other forms of consideration in addition to the interest coupons on the securities, including upfront commitment fees and warrants to acquire our common stock.”  This happened in December with the Fairholme transaction, and it is possible that small shareholders will have their stakes in the company further diluted by the issuance of more common stock to deep-pocketed investors like Fairholme and Leucadia in exchange for their participation in subordinated bond issues.

Then there is Leucadia’s involvement in AmeriCredit.  Leucadia is well known for buying control stakes in distressed companies, turning things around, and then selling the companies to bigger players for a substantial profit.  Indeed, it is likely that Leucadia’s involvement was the reason why Fairholme entered into a position in AmeriCredit in the first place, as Berkowitz highly respects Steinberg and Cummings.  It is entirely possible that Leucadia will help make AmeriCredit the best in class subprime auto finance company and possibly even the best in class auto finance company, period.  The end game may then be for the company to be sold to a big commercial bank which will gain the benefit of AmeriCredit’s lending infrastructure and brand/franchise value.

Fairholme and Leucadia’s shareholders are lucky to have investment managers with the resources and skills to be able to dive into distressed situations, and who are astute enough to recognize investment situations that hold the potential for outstanding returns with a large margin of safety.  Their AmeriCredit investment is nothing less than Buffett-esque.

Disclosure: Please note that while I do not own shares in AmeriCredit (ACF) or Leucadia (LUK), I do currently own shares in the Fairholme Fund (FAIRX).