The Alchemist: Can Warren Buffett Transform Goldman?

Last Updated May 4, 2010 6:25 PM EDT

Warren Buffett knows how to lay down the law with Wall Street, especially scandal-ridden investment banks like Goldman Sachs (GS). "If you lose money for the firm by bad decisions, I will be very understanding," he said. "If you lose reputation for the firm I will be ruthless."

Except that the firm whose rep the "Oracle of Omaha" was determined to save isn't Goldman. That was Buffett in 1991 speaking to employees of Salomon Brothers, where he was the interim chairman and which he controlled as its largest shareholder. The legendary investor had rescued the securities firm after it was caught trying to rig bids for U.S. Treasury notes. In so doing, he'd worked miracles in persuading government officials not to throw the book at Salomon, largely by firing John Gutfreund and John Meriwether, the revered "masters of the universe" who ran the firm.

Nearly 30 years later, Buffett appears to have changed his tune. As one of the largest shareholders in Goldman, he is loudly defending the company against federal allegations that the company defrauded investors in the now-infamous Abacus synthetic CDO. Buffett has also made the media rounds since the SEC announced its lawsuit to throw his support behind Goldman chief vampire squid Lloyd Blankfein.

"I don't have a problem with the Abacus transaction at all," he told shareholders last weekend in attendance at the annual meeting of his Berkshire Hathaway (BRK), adding that investors in the deal should've done their homework.
Buffett's move to lease his good name to a firm that has come to embody Wall Street sleaze is catching some people by surprise. Hypocrite! they cry, citing his previous ridicule of derivatives as "financial weapons of mass destruction." Yet despite his reputation as the anti-Gordon Gekko, Buffett has always walked a fine line between rejecting and exploiting Wall Street.

In some ways, of course, the critics have a point. After all, how do you square the patron saint of long-term "value" investing holding hands with a firm that specializes in making a quick buck? Buffett's entire persona -- homespun, straight-shooting, prudent -- was constructed as the antithesis to the bespoke wizards of Wall Street, whose financial "innovations" raze the economy every few years. Here's Buffett in his guise as soothsayer in Berkshire's 2008 annual report:

Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks.
Going further back, here's what Buffett once had to say about corporate raider T. Boone Pickens, reputedly one of the Wall Street slitherers after whom Gekko was fashioned: "They aren't creating value -- they are transferring it from society to shareholders."

And Goldman isn't?

Yet while Buffett's alliance with Goldman strikes some as odd, it's very much out of his playbook. For one thing, as he did previously with Salomon, Buffett is simply protecting his $5 billion investment in Goldman, which nets Berkshire some $500 million a year in dividends. He has also recently gone to bat for credit ratings agency Moody's (MCO), in which he also owns a stake.

For another, Buffett has long invested in ailing financial firms, preferably during economic downturns. Buffett first took a $700 million stake in Salomon in 1987, after the company was busted trying to corner the government bond market. In the early 1990s, he also spent a total of more than $1 billion to buy into Wells Fargo (WFC) and American Express (AXP), both of which were slumping at the time amid a big recession.

To understand Buffett's M.O., it's important to note that Salomon wasn't your garden-variety securities shop; it was the go-to investment bank for financial exotica. In 1981, it arranged the first debt swap (between IBM and the World Bank), kicking off a boom in the global derivatives business. During the ensuing takeover boom, Salomon invented a range of products, including "Collateralized Automobile Receivables" and the aptly named "Heaven and Hell" bonds. In other words, Buffett was well aware of whom he was bedding down with by the time of his investment in Salomon.

Something else people often forget about that episode was Buffett's explanation for why Salomon went bad. Wall Street's greed-is-good ethos? The proliferation of complex financial products? No -- rogue traders. Said Buffett in Salomon's first quarterly earnings report in 1991 after he'd seized control of the firm:

A few Salomon employees behaved egregiously -- a fact that will prove costly to you as shareholders -- but the misconduct and misjudgments were limited to those few.
Unsurprisingly, that's a self-serving analysis, and history has debunked it thoroughly. Although he later lamented his investment in Salomon, he came out just fine, selling the firm to Travelers in 1997 for $9 billion. Citibank, which inherited Salomon through its 1999 merger with the insurance giant, would emerge as a leading purveyor of derivatives.

As for Goldman, Buffett has evidently concluded that the company can beat whatever government attorneys throw at it. Could be.

Certainly, whatever damage Goldman ultimately suffers to its reputation, Buffett is likely to escape with his intact. Although he continues to pan derivatives (if not quite as chirpily), he's willing to use them. Before taking a big loss on swaps during the housing crash, Berkshire in 2007 netted $3.5 billion in after-tax investment and derivative gains, while its take ranged from $1.7 billion to $3.5 billion in the preceding three years. In 2008, Berkshire started writing credit default swaps.

In this sense, Buffett's greatest achievement isn't to have consistently outpaced the stock market or preserved the legacy of Benjamin Graham. It's his work as an alchemist. He melds financial populism and its traditional disdain for high finance with a speculator's gimlet eye for profit. Investing in Berkshire means never having to say you're sorry.

And whether they know it or not, the groupies who flock to Berkshire's revival meeting in Omaha every year have internalized the master's composite morality. They embrace him not because he reviles firms like Goldman and Salomon, but rather because he praises them.

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    Alain Sherter covers business and economic affairs for CBSNews.com.