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1 Way Warren Buffett Detects Danger in Financial Institutions

Last week, the U.S.’s National Archives released documents related to the U.S. government’s investigation on the causes of the 2007-09 financial crisis. As part of the materials released was a May 2010 interview that Warren Buffett had with the Financial Crisis Inquiry Commission.

Buffett’s one of the best investors in the world today and so, his views on the financial markets may be well worth heeding.

In the interview, Buffett had shared some insights that I think can be very helpful in detecting danger in financial institutions. This can be a very important thing for stock market investors in Singapore.

That’s because Singapore’s banks – which include DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39), and United Overseas Bank Ltd (SGX: U11) – are a very important part of the stock market here. As an example, the trio of banks had collectively accounted for 34% of Singapore’s stock market benchmark, the Straits Times Index (SGX: ^STI), as of 11 March 2016.

Moreover, finance also has a hefty presence in the economic fabric of Singapore. In 2015, the finance and insurance industry made up 12.6% of the country’s gross domestic product.

With all these said, let’s move on to what Buffett had shared. In response to a question on why he had sold his investments in Freddie Mac and Fannie Mae (two large housing mortgage buyers in the U.S.) in 2000, here’s what Buffett said (emphases mine):

Well, I didn’t know that they weren’t going to be good investments, but I was concerned about the management at both Freddie Mac and Fannie Mae, although our holdings were concentrated in Fannie Mac.

They were trying to – and proclaiming that they could increase earnings per share in some low double-digit range or something of the sort. And any time a large financial institution starts promising regular earnings increases, you’re going to have trouble, you know?

I mean, it isn’t given to man to be able to run a financial institution where different interest-rate scenarios will prevail on all of that so as to produce kind of smooth, regular earnings from a very large base to start with; and so if people are thinking that way, they are going to do things, maybe in accounting – as it turns out to be the case in both Freddie and Fannie – but also in operations that I would regard as unsound.

And I don’t know when it will happen. I don’t even know for sure if it will happen. It will happen eventually, if they keep up that policy; and so we just decided – or I just decided to get out.”

In essence, what Buffett’s trying to say is that it can be dangerous when a financial institution starts trumpeting its ability to grow its profits regularly at a certain rate; the natural vicissitudes of conditions in the financial markets make it exceedingly hard for any financial institution – in particular, large ones – to be able to grow smoothly without hiccups.

Buffett’s comment on interest rates in his quote above may also be worth extra attention for current or prospective investors in the trio of bank stocks in Singapore (that would be DBS, OCBC, and UOB). That’s because interest rates in Singapore aren’t controlled by the central bank, the Monetary Authority of Singapore. Domestic rates here have strong links instead with the movement of the Singapore dollar and interest rates in the U.S. This dynamic may result in Singapore’s banking trio having to deal with bumpy interest rates.

Fortunately, there’s currently no sign of the managements of DBS, OCBC, and UOB having set any targets for producing smooth earnings growth in the future. But if there’s ever an occasion when all or any of them would do such a thing, that’s a time when investors may want to sit up and take notice.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.