Crazy on Credit

I was rereading the year-end issue of Outstanding Investor Digest (a terrific, worth-every-penny publication), which includes, as it traditionally does, a summary of Warren Buffett's and Charlie Munger's comments from the Berkshire Hathaway (NYSE:BRK.A) annual general meeting held every May in Omaha, Neb.

In his opening remarks, Buffett discussed the company's recent acquisition of manufactured home producer Clayton Homes. Even in the best of times, manufactured housing isn't a terribly exciting business. In 2002, its participants -- Clayton, Oakwood Homes, Champion Enterprises (NYSE:CHB) and Cavalier Homes (NYSE:CAV) -- got into the soup by issuing enormous amounts of poorly secured credit.

In 2002, the rate of repossession of manufactured homes approached 55% of new homes sold. When that happens, banks generally want nothing to do with providing financing for the companies. Oakwood Homes ultimately entered Chapter 11 protection this past year and agreed to be acquired by Clayton, thus moving it into the Berkshire fold as well.

There is a really important lesson here for investors following housing and banking stocks today. As Buffett put it:

The manufactured home industry got into significant trouble -- very significant trouble -- because credit terms.... Well, they went crazy on credit four or five years ago. And when you go crazy on credit, you suffer in a big way.

With interest rates near historic lows, American households have taken the opportunity to raise some $300 billion by engaging in "cash out" refinancing. This has been huge business for many companies, including such stalwarts as Washington Mutual (NYSE:WM). Unfortunately, while WaMu maintains extremely high loan-loss allowances, many institutions do not.

What grabbed me, though, was when Buffett described the pain that companies felt in 2002 stemming from behavior that must have seemed completely reasonable in 1998. Certainly, the manufactured home sellers didn't intentionally sign off on bad loans. No loan officer approves a loan thinking, "I'll bet we get this one back." They all look fine or good enough given the proper incentives. When the worm turned, however, plenty of borrowers found themselves upside down on their home loans, and simply walked away from their houses or were evicted.

Where might the troubles come from five years from now? Will they come at all? I've no way of knowing, but there's not much chance that I'd be interested in holding a portfolio of mortgages where the borrowers owe 97% or more on their houses. Nor would I be excited to invest in companies that do. It's a great, profitable business, until suddenly it is not.

Bill Mann owns shares in Berkshire Hathaway.