Warren Buffett, the richest man in America, was financially exposed to the housing industry, but managed to avoid severe subprime mortgage losses. Banks and mortgage companies should pay attention to the stock market wizard, and take a lesson from his investment philosophy.

Fortune magazine recently ran a story explaining that legendary stock market investor, Warren Buffett, was exposed to subprime mortgages. But he managed to make the high-cost, high-risk loans without losing his shirt. Had other lenders and Wall Street investors followed his example, the nation might not be facing its worst economic crisis in recent history.

Clayton Homes and subprimes

Berkshire Hathaway, Buffett's investment company, owns Clayton Homes, the nation's largest maker and financier of pre-fabricated and mobile homes. This form of low-end housing often sells to consumers who have credit problems and can't afford more traditional homes. Such borrowers are ideal candidates for subprime mortgages, because they're tailored to people with bad credit, fewer assets, and less income. As the last real estate bull market heated up, the mortgage industry pushed subprimes on consumers in an unprecedented marketing campaign, often making such poor-quality loans to people who didn't need them and would have been better off with less toxic and less expensive prime mortgages. The push backfired, instigating the worst mortgage crisis in history.

Despite the fact that almost half of Clayton's loan portfolio involves borrowers with subprime credit scores, foreclosures for Clayton have dropped within the past two years, falling by more than 20 percent. The delinquency rates are low, and although Clayton has lost money in this current crisis, it has fared much better than its housing and loan industry counterparts.

Avoiding mortgage speculation

Clayton did something differently than the rest of the mortgage industry. Even though it made subprime loans, it didn't compromise its underwriting standards. The company avoided lending to speculators, and didn't offer "teaser rates" as incentives to encourage people to borrow money that would later become challenging to repay. The business also kept its loans in-house instead of selling them to Wall Street as securitized mortgage investments. Fortune quoted Buffett as saying, "When we make a mistake in making or buying a loan, it costs us money, not some buyer thousands of miles away."

People who bought their homes from Clayton and borrowed mortgage money from them intended to keep their property, and valued it as their hearth and home. They didn't buy homes as the bubble expanded in order to flip them for a fast buck. "If people purchased a house with the idea that it would appreciate substantially in the next few years," Buffett wrote to Berkshire shareholders, "they may elect not to make their payment. Since our borrowers did not come in with those expectations, they will quit making payments only when they can't make the payment."

Published on October 29, 2008