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Todd N Kenyon
Articles 

Buffett Warned Us in 2003, Few Listened

September 16, 2008

Warren Buffet foresaw the current financial disaster more than five years ago. I pulled out his 2002 Chairman’s Letter, wherein he addresses derivatives and their potential to scuttle the entire financial system. Here are some key passages:


“Charlie 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.”

“In 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 “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.””

“Another 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.”


“Charlie 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 I’ve 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.”

“In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”


There’s much more, available on the Berkshire website. Warren and Charlie have made some additional comments at the 2007 annual meeting. Munger:

“As 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.”

On the math models used by Wall Street: “They’re all crazy.” “Very smart people do very dumb things” and that just because people “have high IQs” does not prevent them from creating financial models that are “at least 50% twaddle.”

on Berkshire’s underwriting standards: “We only write fire insurance on concrete bridges that are covered by water.”

Buffett: “Not too many years ahead you will get disruption. Predicting when is something we can’t do…(It will reward) those with cash and guts.”

Munger: “Will Rogers said, ‘Learn not to pee on an electrified fence without actually doing it.”

Alas, heeding that last one would’ve 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 don’t all happen at once: that depositors don’t make a run on the bank, insurance liabilities aren’t all claimed at once, derivative contracts don’t all go the same way at the same time, mortgages don’t all default at once. However, as Buffett says and I also heard Bill Ackman paraphrase, when the stuff hits the fan, everything correlates. That’s where we are now.

If you took on too much risk, levered up too much, didn’t prepare for the day when everything correlates… well then adios. See ya. Buh-bye.

Buffett and Munger were not so much prescient as good students of market history and innately conservative. They’d seen it all before in one form or another. I return to Galbraith from his book “A Short History of Financial Euphoria”:

“The 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.”

Obviously Bear, Lehman, Freddie, Fannie, AIG, WaMu, Countrywide, on and on, went with the “lesser adequacy” model.

About the author:

Todd N Kenyon
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 4.3/5 (56 votes)

Comments

roke6362
Roke6362 - 9 years ago    Report SPAM
Very good article. I would say that, right now, people who are liquid should do quite well in the next 2-3 years.

This can now be characterized as a garage sale for the liquid/rich.

Liquidity is king!!
Sivaram
Sivaram - 9 years ago    Report SPAM
Wow... Buffett's word precisely described why AIG went down... thanks for posting this...
cm1750
Cm1750 - 9 years ago    Report SPAM
Very good article.

While WEB may not be a great source for stock picks given his size limitations, his wisdom provides tremendous value in analyzing business models and risk.
Amit Chokshi
Amit Chokshi - 9 years ago    Report SPAM
The love fest with WEB gets so annoying. WEB is an original thinker, funny how so many value investors are just lemmings hoping to shine his shoes. Stop reading what WEB says and go get a 10-K and focus on opportunities in the market. I guess the lazy value way is to read up on value investing and listening to some folksy quotes from WEB, look through a 13F of some value hacks and buy AXP or SHLD and consider oneself a value investor RMLFAO.
alanb9
Alanb9 premium member - 9 years ago
This hate fest with WEB gets so annoying....:)
tnkenyon
Tnkenyon - 9 years ago    Report SPAM
One could argue that because most of Wall Street "stopped reading WEB" we are now in this mess. I understand your annoyance with the copycatting that goes on among the VIC crowd, but that doesn't mean we should stop studying Buffett just because some may inappropriately use him as a marketing tool. I for one would want anyone managing my money to know Buffett/Graham inside-out. And then I would want to know enough about B/G myself to be able to evaluate whether the manager was in fact a true value investor. One could also argue that if the folks who hand money over to 2/20 copycats knew more of WEB's teachings, they might not make that mistake. That said, many of those guys are still doing very well even in the face of some major bad calls.
Amit Chokshi
Amit Chokshi - 9 years ago    Report SPAM
WEB is the best but he sometimes says on thing and does another. One would never recommend writing puts yet he has done that and yes I know it's a specific option where he supposedly won't lose anything. The insurance business itself requires derivatives to be used. Also, let's not forget some of the scandals that have occurred at General Re that are generally blown over since WEB has a halo and can do know wrong. I've learned from the guy, i think he's a six sigma event in terms of people although he's not exactly MLK, Einstein, or Ghandi while plenty of people would put him in that class but I'm not going to make this guy or any value person out to be some god.

Secondly, this crisis is bad but it'll happen again in 5-8 years. This is the mother of crises for now, but its human nature. And "we" are in this crisis as far as being the avg joe and ham and eggers but if you asked scum like Angelo Mozillo if they'd run their business the same way, they probably would considering they made a fortune.

Lastly, WEB doesn't have a care in the world given his economic status. A lot of people got fried in basic money market accounts stuffed with structured products tied to this garbage. Those people were lied to in some cases and because we all know that income growth has sucked since the scum in chief took office, I don't really want to begrudge them for chasing some extra yield when they're main competency isn't financial markets (they have bad advisers) and are trying to make ends meet. For the vast majority of people, you have had a government that cut rates so low that it incentives speculation and when you have no wage growth, your dollar is toilet paper relative to your input costs, and you need to make up that spread, you're almost forced to take higher risk in the junk that was peddled out.

My main point is that spending time discussing what WEB said here and there is fine but for all of these value disciples, the best thing theycan do is try to become a better investor and the only way to do that is tear through financials of companies rather than constantly review his wisdom. Put another way, I've discussed ideas with other value folks and its amazing how funny it is to see that the discussion of companies rarely can extend past a Pabrai, Buffett, Ackman, Einhorn, or Berkowitz holding. Maybe that's unrelated but if these folks stop crowing on about Omaha and some CNBC WEB appearance and maybe go through some original ideas, they'd be closer to reaching the guy they aspire to.

kfh227
Kfh227 - 9 years ago    Report SPAM
Dizzy,

You have to rememer your roots.

One day, you prbaboly thought PE was king.

Then you learned another thing.

Then you learned about Graham and Buffett

Then you starting reading 10Ks, annual reports, etc.

You have evolved. All value investors evolve. People need to learn over time. Not a single person dove directly into reading 10Ks, annual reports, etc. They started at hte bottom (probably not even as anything resembling value investors) and they evolved.

It's not the best path to start at the very bottom (Jim Cramer for example), but everyone goes through a phase of WEB worship. And eventually (hopefully) they make it to annual reports, etc. While the most seasoned of investors may find the WEB worship annoying, don't forget that you were probably (maybe not) in those shoes in the past.

alanb9
Alanb9 premium member - 9 years ago
Dizzy,

I have no intention of getting into a prolonged argument with you, but I do want to give an alternative opinion on some of what you wrote. I'll italicize your quotes:


> WEB is the best but he sometimes says on thing and

> does another. One would never recommend writing

> puts yet he has done that



I have no way of knowing absolutely why it seems he says one thing but does another, but consider this as a possibility: He knows his audience includes many unsophisticated investors and if he started talking about buying and selling options as much as he talks about buying companies, many people would be more likely do the wrong thing. So to talk about derivatives being weapons of mass destruction and then pick and choose some derivatives in which to invest is not inconsistent, it is knowing his audience. Additionally, in the context of his statement equating derivatives as weapons of mass destruction, he wasn't talking about puts and calls on stocks, but the much more esoteric and illiquid stuff that has sunk Bear, Lehman and AIG.

Also, let's not forget

> some of the scandals that have occurred at General

> Re that are generally blown over since WEB has a

> halo and can do know wrong.


If I recall correctly, the scandals at GenRe occurred before BRK bought the company. If so, it wouldn't be a halo effect protecting WEB, it would be reality... he had nothing to do with the problems.

I've learned from the guy,

If you have learned from him then why do you want to convince others not to read his works and learn from him? Sounds like there could be some nefarious motive there. I'm not saying there is, but it could be interpreted that way.

i think he's a six sigma event in terms of people

Maybe. But if you are speaking of the success he has had investing, you need to read, or reread, his essay 'the superinvestors of graham and doddsville.' He answers that charge quite effectively.

although he's not exactly MLK, Einstein, or Ghandi while plenty of people would put him in that class but I'm not going to make this guy or any value person out to be some god.

I agree totally with this. I'd only remove the word "value" in your sentence if I were writing it.


> My main point is that spending time discussing

> what WEB said here and there is fine but for all

> of these value disciples, the best thing theycan

> do is try to become a better investor and the only

> way to do that is tear through financials of

> companies rather than constantly review his

> wisdom. Put another way, I've discussed ideas

> with other value folks and its amazing how funny

> it is to see that the discussion of companies

> rarely can extend past a Pabrai, Buffett, Ackman,

> Einhorn, or Berkowitz holding. Maybe that's

> unrelated but if these folks stop crowing on about

> Omaha and some CNBC WEB appearance and maybe go

> through some original ideas, they'd be closer to

> reaching the guy they aspire to.

>


I think that what most people are going to think when they read this is that you would advise them to ignore the writings of the those who have proven they can do it. Then, they should do it themselves on their own with their own original ideas. My point would be "why reinvent the wheel?" Learn from the masters, who have generously given their instruction for free (or for a relatively small sum it costs to buy a book). Learn the fundamentals, learn Graham, Fisher, Buffett's investing philosophy. Then venture out on your own. However, we have an advantage WEB didn't have... we have forums in which we can bounce ideas around and get ideas from a very diverse group of people. Why shouldn't people take advantage of websites, books and forums?

I know that isn't what you really said, but I do think that is what some will think when they read it.

Thanks for the exchange of ideas.
tnkenyon
Tnkenyon - 9 years ago    Report SPAM
Well put Alanb9...
Amit Chokshi
Amit Chokshi - 9 years ago    Report SPAM
Alan, what I meant about WEB being a six sigma event was him as a person, not saying he was totally lucky. I of course know his 1984 essay but again, you're talking about survivorship bias. The guys he mentioned were all people that went on to succeed, the problem with value investing is that it puts all the onus on analysis on the person and there are many value practitioners that get hammered by value traps and many would be value oriented funds that flop.

As for learning from WEB, my point is that I and i'm sure many here, pretty much know the main tenets of WEB and G&D and I believe it's important to do so but rehashing his various thoughts on this and that adds little value. The point is whether Michael Jordan teaching you how to play bball, Tiger showing you how to swing, Federer teaching you how to hit a forehand, there's that law of diminishing marginal returns at work whereby you really don't "get it" until you "do it."

I'll leave it at that than belabor the point as I tend to do.
adamcz
Adamcz - 9 years ago    Report SPAM
I've got to wonder about the motivations of somebody who logs onto a website called "gurufocus," which is dedicated to the study of investing gurus, and begs the populace to stop worshipping the ultimate guru.
wsjalerts13
Wsjalerts13 - 9 years ago    Report SPAM
Its easy to say when it happens, if thats the case then why didn't the guru(s) who said this shorted the stocks??

Now don't tell me its not smart to short stocks...

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