Wednesday, November 30, 2011

Buffett: Credit Default Swaps Potentially "Very Anti-Social" Instruments

In this CNBC interview, Warren Buffett is asked by Andrew Ross Sorkin if he believes credit default swaps should exist.

Well, Buffett points out that, for sound reasons, individuals can't insure someone else's house:

...because you do not have an insurable interest*, as they call it in the trade. Because once you insure my house against fire and you may decide that, you know, that maybe dropping a few matches around my lawn might be a good idea.

He added that with credit default swaps participants benefit if a place gets into difficulty:

...when a lot of people have an interest in a place getting in trouble, they may start putting out misleading statements...if you were short the stock of a bank, you might hire—and there wasn't any FDIC, you might go out and hire 100 movie extras to stand in front of that bank.

And...

...in effect, you would create your own reality. Now buying credit default swaps and talking about them and causing the price of credit default swaps to go up creates its own reality to some degree. So I think that they are potentially a very anti-social instrument.

This was Charlie Munger's take on credit default swaps when the worst of the financial crisis had begun to recede. As usual he's unequivocal. According to this Bloomberg article, Munger says he supports a complete ban so speculators can't profit from the failure of others. 

From the article:

Berkshire's Munger Favors '100% Ban' on Credit Swaps

"If I were the governor of the world, I would eliminate it entirely -- 100 percent...That's the best solution. It isn't as though the economic world didn't function quite well without it, and it isn't as though what has happened has been so wonderfully desirable that we should logically want more of it."

Here's one of many reasons why I won't be holding my breath on something reasonably intelligent being done about credit default swaps (and, for that matter, some other forms of speculation) anytime soon. In this The Atlantic interview (also mentioned in this previous post), John Bogle paraphrases a quote by Upton Sinclair that pretty much sums it up:

"It's amazing how difficult it is for a man to understand something if he's paid a small fortune not to understand it."

So, with that in mind, better to have realistic expectations about whether the most logical financial system changes will happen.

Entrenched interests are "paid a small fortune not to understand" why the casino should be reigned in.

They're also paid to not understand why speculative activities should be kept more separate from the core banking utility function.

Sinclair would understand the forces at work here.

Adam

Related posts:
The Bond Market Rules
Sinking Seaworthy Ships

* Insurable interest is a fundamental principle in the insurance business that came about long ago for some very good reasons. From a historical perspective, it was the United Kingdom that provided leadership in this area. It had been learned the hard way from vast experience the lack of an insurable interest creates moral hazard. They sought to remove the ability to profit from another's loss and the misconduct associated with it. The principle hasn't served us too badly over the centuries. Human nature hasn't changed.
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