Warren Buffet foresaw the current financial disaster more than five years ago. I pulled out his 2002 Chairmanās Letter, wherein he addresses derivatives and their potential to scuttle the entire financial system. Here are some key passages:
āCharlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.ā
āIn recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great āearningsā ā until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. āMark-to-marketā then turned out to be truly āmark-to-myth.āā
āAnother problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.ā
āCharlie and I believe, however, that the macro picture is dangerous and getting more so. Large
amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as Iāve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.ā
āIn our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.ā
Thereās much more, available on the Berkshire website. Warren and Charlie have made some additional comments at the 2007 annual meeting. Munger:
āAs sure as God made little green apples this will lead to big trouble in due time. This will lead to a result we have been expecting for some time.ā
On the math models used by Wall Street: āTheyāre all crazy.ā āVery smart people do very dumb thingsā and that just because people āhave high IQsā does not prevent them from creating financial models that are āat least 50% twaddle.ā
on Berkshireās underwriting standards: āWe only write fire insurance on concrete bridges that are covered by water.ā
Buffett: āNot too many years ahead you will get disruption. Predicting when is something we canāt doā¦(It will reward) those with cash and guts.ā
Munger: āWill Rogers said, āLearn not to pee on an electrified fence without actually doing it.ā
Alas, heeding that last one wouldāve saved Wall Street many times.
The financial system is built upon leverage. Its very existence depends on lack of correlation - the requirement that bad things donāt all happen at once: that depositors donāt make a run on the bank, insurance liabilities arenāt all claimed at once, derivative contracts donāt all go the same way at the same time, mortgages donāt all default at once. However, as Buffett says and I also heard Bill Ackman paraphrase, when the stuff hits the fan, everything correlates. Thatās where we are now.
If you took on too much risk, levered up too much, didnāt prepare for the day when everything correlatesā¦ well then adios. See ya. Buh-bye.
Buffett and Munger were not so much prescient as good students of market history and innately conservative. Theyād seen it all before in one form or another. I return to Galbraith from his book āA Short History of Financial Euphoriaā:
āThe rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes it distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.ā
Obviously Bear, Lehman, Freddie, Fannie, AIG, WaMu, Countrywide, on and on, went with the ālesser adequacyā model.
āCharlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.ā
āIn recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great āearningsā ā until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. āMark-to-marketā then turned out to be truly āmark-to-myth.āā
āAnother problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.ā
āCharlie and I believe, however, that the macro picture is dangerous and getting more so. Large
amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as Iāve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.ā
āIn our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.ā
Thereās much more, available on the Berkshire website. Warren and Charlie have made some additional comments at the 2007 annual meeting. Munger:
āAs sure as God made little green apples this will lead to big trouble in due time. This will lead to a result we have been expecting for some time.ā
On the math models used by Wall Street: āTheyāre all crazy.ā āVery smart people do very dumb thingsā and that just because people āhave high IQsā does not prevent them from creating financial models that are āat least 50% twaddle.ā
on Berkshireās underwriting standards: āWe only write fire insurance on concrete bridges that are covered by water.ā
Buffett: āNot too many years ahead you will get disruption. Predicting when is something we canāt doā¦(It will reward) those with cash and guts.ā
Munger: āWill Rogers said, āLearn not to pee on an electrified fence without actually doing it.ā
Alas, heeding that last one wouldāve saved Wall Street many times.
The financial system is built upon leverage. Its very existence depends on lack of correlation - the requirement that bad things donāt all happen at once: that depositors donāt make a run on the bank, insurance liabilities arenāt all claimed at once, derivative contracts donāt all go the same way at the same time, mortgages donāt all default at once. However, as Buffett says and I also heard Bill Ackman paraphrase, when the stuff hits the fan, everything correlates. Thatās where we are now.
If you took on too much risk, levered up too much, didnāt prepare for the day when everything correlatesā¦ well then adios. See ya. Buh-bye.
Buffett and Munger were not so much prescient as good students of market history and innately conservative. Theyād seen it all before in one form or another. I return to Galbraith from his book āA Short History of Financial Euphoriaā:
āThe rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes it distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.ā
Obviously Bear, Lehman, Freddie, Fannie, AIG, WaMu, Countrywide, on and on, went with the ālesser adequacyā model.
