Wednesday, August 3, 2011

Buffett on Derivatives: The 'Chain Reaction' Threat

"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." - Warren Buffett in the 2002 Berkshire Hathaway Shareholder Letter

When Berkshire Hathaway (BRKa) purchased Gen Re, along with it came with General Re Securities, a derivatives dealer that Warren Buffett and Charlie Munger did not want.

They viewed the derivatives operation as dangerous and wanted to be rid of it but couldn't sell.

So they decided to terminate it. Ten months into winding down the operation still had 14,384 contracts outstanding involving 672 counterparties around the world.

That's someone who wanted out of the derivatives business. Imagine the complexity of those institutions who are perfectly happy to engage extensively in this type of activity to this day.

Buffett explained why he thinks derivatives are dangerous in the 2002 Berkshire Hathaway letter.

Back then, Buffett couldn't have guessed the specific events that would trigger the paralyzing systemic instability and resulting economic damage we all witnessed in 2008.

Yet, I think the following pretty well describes what was at the root of the financial meltdown that happened six years later. From the 2002 letter:

"In banking, the recognition of a 'linkage' problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a 'chain reaction' threat exists within an industry, it pays to minimize links of any kind. That's how we conduct our reinsurance business, and it's one reason we are exiting derivatives.

Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.

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."

Unfortunately, the linkage problem and chain reaction threat still remains a serious risk. We have not done enough post-crisis to reduce it.

The analysis of any financial institution, even if you read every last footnote in a companies annual report, ends up being a giant leap of faith.

There is no practical way to get a clear picture of the risks that an individual institution is running when it comes to their derivatives activities. So it certainly is not possible to gauge the risks to the system as a whole at any point in time.

We'd be wise to change this. Somehow neither Long-Term Capital Management in 1998 or the financial crisis of 2008 was enough of a lesson.

It brings to mind a scene from the movie Citizen Kane. In the scene, a stubborn self-obsessed Charles Foster Kane facing a scandal forsakes good sense and reason. Seeing this lack of good sense, Kane's political opponent Boss Jim Gettys says the following:

"You're the greatest fool I've ever known, Kane. If it was anybody else, I'd say what's going to happen to you would be a lesson to you. Only you're going to need more than one lesson. And you're going to get more than one lesson."

So Kane strikes Boss Gettys as a fellow who'll NOT learn a lot of hard lessons and, of course, he goes on to do just that.

Either we reduce the risks to the system caused by this garbage or future events will force us to in more painful ways.

"When the regulators put in the option exchanges, there was just one letter in opposition saying 'you shouldn't do this,' and Warren Buffett wrote it.

Then, next, derivative trading made the option exchange look like a benign event. So just one after another the very people who should have been preventing these asininities were instead allowing foolish departures from the corrective devices we'd put in the last time we had a big trouble—devices that worked quite well." - Charlie Munger in the Stanford Lawyer

I'd rather us not wait for the next "lesson" to do what makes sense.

Adam

Long position in BRKb

Related posts:
Munger on Derivatives
Buffett on Derivatives

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