Warren Buffett: How to Avoid Going Broke

It's only when the tide goes out that you learn who's been swimming naked.

- Warren Buffett (1992)

If Warren Buffett, the chairman and CEO of Berkshire Hathaway (NYSE: BRK-A  )   (NYSE: BRK-B  ) , repeats an idiom on numerous occasions throughout multiple decades, then it's probably not a bad idea to figure out what he means by it. His is, after all, the greatest investor of all time.

And so it is with his warning that "It's only when the tide goes out that you learn who's been swimming naked." By my count, he's written some variation of this in four separate shareholder letters spanning the years 1992 to 2007.

Buffett, a bathing suit, and Hurricane Andrew
I trust it's obvious that Buffett isn't speaking literally here. While the 83-year-old billionaire is fond of sexual metaphors -- in 1974, for instance, he described feeling like an "oversexed man in a harem" thanks to an abundance of bargains in the stock market at the time -- there's little evidence he either skinny-dips himself or hangs around others that do.

Instead, Buffett is referring to the more mundane tendency of financial companies to overextend when times are good only to regret their imprudence when the tide eventually (and inevitably) turns.

The year 1992 serves as an apt example. In August, large swaths of Florida and the Gulf Coast were ravaged by Hurricane Andrew. An estimated 63,000 homes were destroyed, causing the deaths of 65 people, and leaving roughly 175,000 other Americans homeless. It was the costliest hurricane in U.S. history, with a final tally of $26 billion worth of damage -- adjusted for inflation, that's equivalent to $43.7 billion today.

The impact on the insurance industry was equally alarming. As Buffett recounted in his shareholder letter that year, a number of small insurers were destroyed, a major insurer "escaped insolvency solely because it had a wealthy parent that could promptly supply a massive transfusion of capital," and countless others were awakened to the fact that their own insurance against catastrophe, known as "reinsurance," was far from adequate.

In the absence of Hurricane Andrew, these companies would have continued to tout their underwriting discipline and profitability. Because of it, however, many were rendered in or on the cusp of insolvency. And herein lies Buffett's point that you only know who's been swimming naked when the tide goes out.

Insurance companies aren't the only businesses that swim naked
The validity of Buffett's observation extends beyond insurance companies. Most notably, the business of banking is just as susceptible to the same tendency to overindulge when times are good and then purge when the credit cycle inverts.

Perhaps nothing illustrates this better than the housing debacle that first reared its head in 2007. Mortgage lenders, including many of the biggest and best known banks in the country, had spent the previous five years underwriting trillions of dollars' worth of subprime loans to aspiring homeowners who had little to no hope of ever paying them back.

Yet, along the way, lenders were assuring their investors that everything was fine; that they were continuing to apply the same level of caution in the underwriting process as ever before. As late as July 2007, for instance, the CEO of Wachovia, the nation's fourth largest bank by assets at the time, was praising his bank's balance sheet growth and risk management.

In risk management, I am particularly happy with their position in a very difficult environment.

Net charge-offs continue to be a very low 14 basis points. [Nonperforming assets] increased for us slightly in this quarter; that was primarily in mortgage. But if you compare our mortgage company to almost any other in the industry, our NPAs are outstanding, and our NPAs at a company level would have to be considered outstanding in comparison to our peer group.

Lastly, we are very comfortable with where we sit today in a conservative position in virtually all asset classes as markets reprice risks

Sadly, nothing could have been further from the truth. A little over a year later, Wachovia's losses thanks to imprudent underwriting rendered it insolvent, forcing the government to step in and broker its sale to Wells Fargo (NYSE: WFC  ) . To Buffett's point, in turn, it's only when the tide goes out that you know who's been swimming naked.

The Foolish takeaway
The takeaway here is simple. At least when it comes to insurance companies, banks, and other leveraged financial companies, investors would be wise to apply a healthy dose of skepticism to the pronouncements of executives. Take these for what they are: self-interested statements by people who are heavily compensated to make them.

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