Sadly, I won’t be in Omaha tomorrow for the Berkshire Hathaway annual meeting. It’s a shame because as a financial sector analyst, it’s always instructive to hear what Warren Buffett says about the industry. Finance is one of his biggest bets – it makes up 30% of his equity portfolio and, through his insurance businesses, the largest part of his operating holdings. His passion for the financial sector goes back a long way. “[Insurance company] GEICO was my first business love,” he once declared. 

While his love of insurance is fairly well known, Buffett has allocated a lot of time and capital to banks over the years, too. “We feel it’s something that we can – that falls within our circle of competence to evaluate… We don’t think it’s beyond us to understand the banking business. And so, it’s – we look at businesses in that area.” In fact, if it wasn’t for a legal change way back in 1969, his allocation to banking would likely be even higher. 

Ahead of tomorrow’s meeting then, I thought it would be fun to review several of Buffett’s largest financial sector trades outside of insurance. I’ve picked six: Illinois National Bank and Trust Company, American Express, Salomon Inc, Wells Fargo, Bank of America and his more recent foray into fintechs. 

Together, they give insight into Buffett’s process and how it has evolved over the years. For readers with less experience analysing financial companies, the stories around each provide useful lessons in the ups and downs of being an investor in financial stocks.

Owning a Bank: Illinois National Bank and Trust Company

Buffett is known for his minority stakes in Wells Fargo, Bank of America and other banks, but he once used to own an entire bank. He bought it in 1969, after two or three years of research. “Charlie and I went and looked – we must have looked at a half dozen banks… We trudged around and we found some very oddball banks that we liked.”

They picked Illinois National Bank and Trust Company of Rockford, Illinois. The bank was run by its founder, Eugene “Gene” Abegg, who’d set it up in 1931 and shepherded it through the Depression. By the time Warren and Charlie came knocking, it was the largest bank in the second largest city in Illinois, with net assets of $17 million and a deposit base of $100 million. 

Buffett paid just over book value for the bank in a deal that kept Gene Abegg at the helm. Another bidder offered a million dollars more, but Abegg – who owned a quarter of the stock – wanted to work under Buffett. The admiration was mutual. Buffett later commented that Gene worked harder for him than he had for himself.

“He carried around thousands of dollars of cash in his pocket, and he cashed checks for people on the weekends. He carried a list of the numbers of unrented safe-deposit boxes with him everywhere and would try to rent you a safe-deposit box at a cocktail party.”

In its first full year of Buffett’s ownership, Rockford Bank – as it was colloquially known – made an operating profit of $2.2 million, equivalent to a 1.9% return on assets, placing it among the most profitable commercial banks in the country and revealing the price Buffett paid as a steal. But before Buffett could get too used to perpetual returns like this, the law changed, making long-term ownership of the bank difficult. In 1970, Congress amended the Bank Holding Company Act of 1956 to include one-bank holding companies. If Buffett wanted to continue owning Rockford Bank, he wouldn’t be able to hold non-banking businesses within Berkshire Hathaway as well. The law gave him ten years to divest the banking business.

So, ten years later, in 1980, Buffett conducted a rare spin-off of a business. He announced an exchange ratio between stock of Rockford Bancorp Inc. and stock of Berkshire, and let shareholders make the decision as to whether to exchange all, part, or none of their Berkshire shares for Rockford shares. “This technique embodies the world’s oldest and most elementary system of fairly dividing an object. Just as when you were a child and one person cut the cake and the other got first choice, I have tried to cut the company fairly, but you get first choice as to which piece you want.” At the time, Berkshire had around 1,300 shareholders; 65 of them – including Buffett – chose to become direct shareholders of Rockford Bank. 

Over the time Berkshire owned it, Rockford Bank generated an annualised return on equity of 15%. Along the way, Buffett took out over $20 million of dividends – more than he had paid for the bank. Buffett warned it would be a difficult asset to replace: “You simply can’t buy high quality businesses at the sort of price/earnings multiple likely to prevail on our bank sale.”

Fast forward many years though, and the bank ended up doing quite badly. For five years after the spin, it stayed independent before merging with American National Bank to become Amcore Bank in 1985. Amcore didn’t survive the financial crisis. Saddled with bad commercial real estate and land development loans, it was closed down by regulators one Friday evening in April 2010, its deposits transferred to Harris Bank, part of the Canadian Bank of Montreal. Gene Abegg must have turned in his grave. Unlike his successors, “Gene never forgot he was handling other people’s money.”

American Express and the Great Salad Oil Swindle

Financial companies have a tradition of courting disaster, and Buffett’s names are no exception. In some cases, disaster strikes long after he has exited, like in the case of Amcore. In others, Buffett is tasked with riding out the disaster, such as in the cases of Wells Fargo and Salomon, discussed later on. In the best cases, though, Buffett is able to profit from disaster. His first experience of this was American Express.

Back in the early 1960s, American Crude Vegetable Oil was the leading player in the US soybean market. Its founder, Anthony “Tino” De Angelis, was known as “The King of Salad Oil”. From his base in Bayonne, New Jersey, just over the Hudson River from Wall Street, De Angelis would trade massive volumes of soya and other vegetable oils with customers around the world.

But he wasn’t entirely straight. In order to finance his operations – and his lifestyle – De Angelis borrowed from banks against the value of oil sitting in his storage tanks. By rigging up elaborate plumbing systems inside his tanks and exploiting the chemical property that oil floats on water, he was able to trick storage inspectors into thinking he had a lot more oil on hand than he did. His borrowing grew and grew on the back of this fraud. At one point, inspectors unquestioningly authenticated an amount of oil larger than total US production. 

The organisation sending in the inspectors was a subsidiary of American Express. Established a few years earlier to target this new “field warehouse” market, its management worked with the view that its customers were basically honest. “They ought to know what is in their own tanks,” reported the subsidiary’s CEO.

When the fraud came to light – the weekend following President Kennedy’s assassination – American Express found itself on the hook for $150 million in guarantees. The company’s stock collapsed. Uniquely, American Express was structured as a joint stock association, meaning that shareholders were potentially liable – no-one wanted to hold it. 

For Buffett, it presented an interesting opportunity. His analysis of American Express’ core credit card and traveller’s cheque businesses convinced him that there was value in the stock. 

“I went out and did a little check to make sure this thing wasn’t affecting them and we bought 5% of the American Express Company for $20 million, which means the whole company was selling for about $150 million at that time. The whole American Express Company, synonymous with financial integrity and money substitutes around the world. When they closed the banks, when Roosevelt closed the banks, he exempted American Express Traveler’s Checks, so they substituted as US currency. It was not a business that should have been selling for $150 million, but everyone was terrified.”

It was the largest investment Buffett had made, amounting to 40% of his partnership’s capital. But it paid off. The following year, American Express did $12.5 million in earnings, and it grew from there. 

Thirty years later, Buffett, now with Berkshire money behind him, cast his eye over American Express once again. He’d bought $300 million of a convertible instrument issued by the company in 1991. When it was time to convert to common stock in 1994, Buffett wasn’t so sure. “Amex faced relentless competition from a multitude of card-issuers, led by Visa. Weighing the arguments, I leaned toward sale.”

But a golf game with the CEO of Hertz caused him to change his mind. “Frank [Olson] is a brilliant manager, with intimate knowledge of the card business. So from the first tee on I was quizzing him about the industry. By the time we reached the second green, Frank had convinced me that Amex's corporate card was a terrific franchise, and I had decided not to sell. On the back nine I turned buyer, and in a few months Berkshire owned 10% of the company.”

Buffett went on to add to that position and has held it for many years. Through share buybacks, he now owns over 20% of American Express. Today, he cites it as an example of learning from other people to complement what he learns from reading. “I couldn’t have talked to a better guy than Frank Olson… he could give me an answer in five minutes that would be better than I could accomplish in hours and hours and hours or weeks of roaming around and doing other things.”

Salomon Brothers: Jerome Powell Saves the Day

Many, many years before he became chairman of the Federal Reserve, Jerome Powell helped save Warren Buffett $700 million. 

Buffett was an investor in Salomon Inc. He’d bought $700 million of convertible preferred stock in 1987, the largest amount he’d ever invested in a single company. The preferred yielded 9% and was convertible after three years into common stock at a price of $38 per share – against the $30 the stock was trading at the time of the transaction.

“The close association we have had with John Gutfreund, CEO of Salomon, during the past year has reinforced our admiration for him. But we continue to have no great insights about the near, intermediate or long-term economics of the investment banking business: This is not an industry in which it is easy to forecast future levels of profitability. We continue to believe that our conversion privilege could well have important value over the life of our preferred. However, the overwhelming portion of the preferred’s value resides in its fixed-income characteristics, not its equity characteristics.”

Their large holding gave Buffett and Munger seats on the Salomon board. For the first few years, they observed proceedings and happily clipped their coupons. Liar’s Poker hit bookstores, making John Gutfreund famous, but it didn’t shake the reputation of the firm. Salomon’s stock rose to $37, bringing the equity component of the trade closer to profitability. 

But then Salomon got mired in a massive scandal. In late 1990 and then again in early 1991, two of its government bond traders broke new bidding rules, put in place to stop firms cornering the market in Treasury securities. More importantly, it took two months for one of the traders to escalate the incident to management and then another four months for management to escalate it to the authorities. Even then, management failed to inform the board of a sharply written letter they had received from the Federal Reserve demanding an urgent investigation. 

When news of the incident emerged, the market panicked. Salomon was heavily reliant on short term funding sources and its access to the market got closed off. The board went into crisis mode. They fired Salomon’s senior management team and installed Buffett as interim chairman.

Before he’d even got his feet under his new desk, Buffett was forced into an urgent negotiation with the Fed. Appalled with the way that Salomon had handled the matter, regulators announced a ban on the firm, preventing it from bidding at Treasury auctions both on its own account and for customers. Such a move was a death knell for Salomon. Buffett mustered all his energy to convince them to rescind. The ban was announced on a Sunday morning, “the most important day of my life”. On Sunday afternoon, Buffett took a call from Jerome Powell, then an assistant secretary at the Treasury. Powell informed him that the government had agreed to lift the ban on Salomon’s bidding for its own account. While not a full reprieve, the reversal sent a signal to the market that the Treasury thought Salomon was okay. 

Buffett stayed in the job for nine months. His track record turning around Salomon gave him first hand business experience that would inform the way he looked at banks, and investment banks, for many years to come. “Lose money for the firm, and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.” It’s a lesson that would repeat many years later at Wells Fargo.

Wells Fargo: Being Greedy When Others are Fearful

Warren Buffett’s most famous aphorism is: “Be fearful when others are greedy, and be greedy when others are fearful.” He first rolls it out in his shareholder letter of February 1987, but laments that, “little fear is visible in Wall Street. Instead, euphoria prevails.” Within three years, though, an opportunity presented itself to put the philosophy into practice. 

In 1990, recession began to drag down back stocks. “Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled…investors understandably concluded that no bank's numbers were to be trusted.” Wells Fargo stock was hit especially hard on fears that West Coast real estate prices would tumble, adding to the losses of those banks with exposure; at one point its stock was down 50%. 

Buffett reasoned that Wells Fargo had sufficient earnings power to weather the storm.

“Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank’s loans – not just its real estate loans – were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.”

Buffett calculated that the stock was trading at less than five times earnings. He scooped up $290 million worth, giving him a 10% interest in the bank. The Bank Holding Company Act may have prevented him from owning a bank in its entirety but it didn’t stop him thinking in terms of full ownership. 

“At Wells Fargo, a $53 billion bank, our 13% ownership translates into a $7 billion ‘Berkshire Bank’ that earned about $100 million during 1994.”

Over the years, Buffett opportunistically increased his stake. Between 2004 and 2014, he invested $11 billion in Wells Fargo stock, turning it into his largest holding (before he bit on Apple).

Then, in 2016, scandal hit. We discussed it here before in Wells Fargo’s Rehabilitation. One of the key ingredients to Wells Fargo’s financial success had been its cross-selling strategy. According to the company, average profit from customers with eight products was five times higher than those with three. To boost sales, the company crafted an incentive plan that assigned branch managers with product quotas and dished out performance bonuses if they were met.

It was Charlie Munger himself who once said, “Show me the incentives and I will show you the outcome.” So it’s perhaps no surprise that corruption crept in. Employees forged signatures and opened accounts in customer names without their knowledge. In September 2016, Wells Fargo admitted that employees had opened as many as 2 million accounts without customer authorisation over a five year period, later raising the estimate to 3.5 million. 

Although the financial impact on Wells Fargo was muted, the reputational impact was huge. An independent review in 2017 criticised the bank’s leadership, sales culture, performance systems and organisational structure as root causes of the scandal. The CEO was forced to go and his successor didn’t stick around for long either. In early 2018, the Federal Reserve announced that it would restrict the bank from growing any larger than its total asset size as of end 2017. 

Buffett didn’t react immediately, but a few years later he began selling his stock. By the end of 2021, he was left with just a small residual position worth $32 million. He recounts two lessons. One, the downside of poorly crafted incentive programmes; and two, the importance of not delaying when problems arise. The latter is an issue that afflicted both Salomon and Wells Fargo, and it’s something Buffett is keenly aware of in his own organisation.

Bank of America: Trading from the Bathtub

The story goes that Warren Buffett was in his bathtub when he got the idea about making an offer to invest in Bank of America via preferred stock. It was 2011 and the bank was still suffering the aftershocks of the financial crisis. The bank “was subject to a lot of rumours, terrible I mean, lots – big short interest, morale was terrible, and everything else. It just struck me that an investment by Berkshire might be helpful to the bank and might make sense for us.”

To make his offer, he needed to speak to Brian Moynihan, Bank of America’s relatively new CEO. Without his number to hand, he tried reaching him through the bank’s call centre. Not having much luck, his assistant eventually contacted the right parties and got Moynihan on the phone. 

The deal involved a $5 billion preferred stock investment at a 6% dividend rate combined with warrants to buy 700 million shares of Bank of America stock at $7.14 a share. Buffett was right in his analysis that an investment by Berkshire might be helpful both to the bank and himself. News of the deal sent Bank of America stock up so that by the close of business Buffett had already made a billion dollar unrealised gain on his warrants. 

A few years later, Moynihan called to renegotiate. To make Buffett’s investment eligible as tier 1 regulatory capital, he would need to cancel the right for dividends to be cumulative – in other words, if a dividend had to be skipped because the bank couldn’t afford it in any given year, there was to be no obligation to ‘catch up’ the following year. Buffett agreed, as long as the preferred stock would remain outstanding for at least five more years. By now, the unrealised gain on the warrants was up at $6.4 billion and in addition, Buffett had locked in a 6% dividend on $5 billion of capital for five years.

Buffett ultimately exercised his warrants in 2017 and sold the preferred stock to cover the cost. By the end of that year, his gain stood at $20 billion. Since then, Buffett has increased his stake in the market, buying in stages over 2018, 2019 and 2020. He even had to request special permission from regulators to take his stake above 10% – it is now 12.8%. (A stake of 25% or more would require Berkshire to convert to a bank holding company). 

Right now, Buffett’s stake in Bank of America is worth $38 billion, reflecting a gain over $23 billion (down from a peak of $31 billion at the end of 2021). Add in $4.4 billion of dividends taken out along the way ($1.65 billion on the preferreds and the rest on the common) and that’s quite a return!

Buffett credits the investment less with the bathtub and more with his having followed Bank of America over many years.

“But the bathtub really was not the key factor. The truth is, I read a book more than 50 years ago called Biography of a Bank. It was a great book, about A.P. Giannini [founder of Bank of America] and the history of the bank. And I have followed the Bank of America, and I’ve followed other banks, you know, for 50 years.”

It’s a playbook he’s used before, one that underpins his investments in GEICO, American Express, Coca-Cola and the Washington Post. As long ago as in 1998 he said, “And the one advantage of allocating capital is that an awful lot of what you do is cumulative in nature, so that you do get continuing benefits out of things that you’d done earlier. So by now, I’m probably fairly familiar with most of the businesses that might qualify for investment at Berkshire.”

Despite that, a few years after making the Bank of America investment he said, “I’ve spent a lot of time in the bathtub since, and nothing’s come to me. Clearly, I either need a new bathtub or we got to get in a different kind of market.”

Fintechs: Investing in Technology

I got to meet Warren Buffett in 2017. I asked him about the disruptive influences of technology on businesses he previously thought unimpeachable. His answer drew on his experiences in the newspaper and retailing industries; he didn’t mention banking.

That’s not to say he wasn’t thinking about it. In September 2018, Buffett invested $300 million for a 2.6% stake in Indian fintech company, Paytm. “Berkshire’s experience in financial services and long-term investment horizon is going to be a huge advantage in Paytm’s journey of bringing 500 million Indians to the mainstream economy through financial inclusion,” said Paytm’s founder at the time. 

Since then, Paytm has gone public and it hasn’t done that well. It came to the market at a $20 billion valuation, compared with the $10 billion at which Buffett invested – but the stock is down 73% since. In March, the Reserve Bank of India barred the company from onboarding new customers because of supervisory concerns. Reputational issues strike again. 

Buffett has had more success in Brazil, where he invested in Nubank in June 2021. His initial pre-IPO investment of $500 million earned him an $150 million gain when the company went public later in the year. He subsequently raised his stake to $1 billion. For Buffett, it’s still not that big a position – it ranks as Berkshire’s 25th largest public holding. But he hasn’t talked much about it in the past, nor articulated his rationale for increasing his stake.

Many years ago, a ten year old boy stood up at the annual meeting to ask about the impact of the internet. “I know you won’t invest in technology companies, but are you afraid that the internet will hurt some of the companies that you do invest in, such as The Washington Post or Wells Fargo?” That boy is now 32 years old and although we have an answer to the Washington Post part of the question, we don’t yet have an answer to the Wells Fargo part. With his Nubank position, Buffett may finally have a way to address it – we may find out more tomorrow.

Further reading: I wrote about Buffett’s insurance strategy in Other People’s Money. Frederik Gieschen wrote a very good piece questioning Buffett’s Reading Obsession. Adam Mead’s book, The Complete Financial History of Berkshire Hathaway is a great combination of financial analysis, narrative and historical perspective making it a hugely valuable addition to the Buffett canon.