Five Years After The Crisis...

It's been a little more than five years since the financial crisis really kicked into high gear.

With that in mind, I decided to re-read some of the things Warren Buffett and Charlie Munger were writing and saying -- well before the crisis began -- a decade or so ago. At the time both were becoming uneasy, I think it's fair to say, with the increasingly pervasive use of derivatives, combined with excessive leverage (often masked by the derivatives themselves), and the resulting rather complex -- nearly impossible to understand -- yet concentrated interconnectedness within the evolving financial system.

At the Berkshire shareholder meeting back in 2003, a bit more than five years before the financial crisis was to begin, Charlie Munger said the following:*

In engineering, people have a big margin of safety. But in the financial world, people don't give a damn about safety. They let it balloon and balloon and balloon. It's aided by false accounting. I'm more pessimistic than Warren. I'll be amazed if we don't have some kind of significant blowup in next 5-10 years.

So Charlie was clearly uncomfortable with the direction the financial world was going and, as it turned out, was all too right to be.

He was rightly concerned at the time and his relative pessimism to Warren Buffett was well-warranted.

Though Buffett was far from not concerned. He said the following at the same meeting:

Derivatives are advertised as shedding risk for the system, but they have long crossed the point of decreasing risk and now increase risk. The truth is that Coca Cola could handle risk [I think he was talking about currency exposure], but now with every company transferring risk to very few players, they are all hugely interdependent.

He also added:

When you start concentrating risk in institutions that are highly leveraged, [watch out].

We all now know how the toxic the combination of excessive leverage and, due to rampant use of increasingly complex derivatives, hugely interdependent financial institution would become. Yet, at the time, there was little more than a passing interest in their warnings.

Little to no proactive action was taken. I don't consider this particularly surprising but that's just the reality.

Buffett had already taken some time to more fully explain their views on derivatives in the 2002 Berkshire Hathaway shareholder letter. Below are some excerpts from the Derivatives section of the letter along with some comments:

Derivatives as time bombs
"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."

What reinsurance, derivatives, and hell have in common
"In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability."

Errors of optimism
"Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one's commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on 'earnings' calculated by mark-to-market accounting."

Unfortunately, as Buffett points out, many times there is no real functioning market for a particular derivatives contract. As a result "mark-to-model" is used.

He goes on to say:

"In extreme cases, mark-to-model degenerates into what I would call mark-to-myth."

Asymmetrical marking errors
"I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive 'earnings' (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham."

Buffett goes on to point out that derivatives can create a "pile-on effect" since some contracts, at what turns out to be an inopportune time, require collateral to immediately be posted for counterparties. Suddenly there is this huge unexpected need for cash that just isn't readily there.

This ultimately can lead to liquidity crisis.

"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."

We saw this during the financial crisis but Buffett was writing this long before what we now know had played out.

The 'linkage' problem
"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."

Micro vs Macro
"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."

One of the problems with many derivatives instruments is that they "make a joke of margin requirements." They allow leverage to build up in the system in ways that would not otherwise be possible.

"The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear."

Buffett closes by saying:

"Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

The section on derivatives in Buffett's letter was released as an article in Fortune in March of 2003. The reason? Warren Buffett thought it important enough that it reach a wider audience.

I'd say that was a wise and well-intentioned thing to do even if those who could/should have paid attention chose to do otherwise. There was plenty of time for a course correction but those with the power to do so simply did not.
(That few considered carefully the warnings then changed their behavior is unsurprising when one considers the vast sums of money involved, the incentives and culture in place and, well, just human nature itself.)

It's still well worth reading what Warren Buffett had to say back then in its entirety. He had it just about right and Charlie Munger, if anything, even more so.

Of course, they were not exactly the only two people who were warning this all would end up very badly.

A number of others understood it well.

The reality is that severe overconfidence too often precedes -- or at least contributes to -- financial folly (LTCM comes to mind).

At times, overconfidence might merely hurt results but, at extremes, it can end up being a terribly destructive thing.

It may be only one of the many seeds of financial destruction, but sure ranks as an important one.**

Certainly more so than some might like to think.

Now, I happen to think it takes a special form of overconfidence -- and feel free to choose somewhat harsher words, where applicable, to describe this tendency -- to not consider carefully what the likes of Warren Buffett and Charlie Munger are saying.
(Especially when it comes to financial matters, though not necessarily limited to financial matters.)

I'm not at all suggesting that they're somehow never wrong.

It's just that they are so often very right.

Adam

Related posts:
Investor Overconfidence Revisited
Investor Overconfidence
Investors are Often Their Own Worst Enemies, Part II
Investors are Often Their Own Worst Enemies
Berkshire Hathaway's Derivatives Portfolio
Berkshire Hathaway: Earnings and the Derivatives Portfolio
The Illusion of Skill
The Illusion of Control
Buffett on Derivatives: The 'Chain Reaction' Threat
Munger on Derivatives
Charlie Munger on LTCM & Overconfidence
Buffett on Derivatives
When Genius Failed...Again

* From notes taken by Whitney Tilson.
** Some consider the tendency toward excessive confidence and optimism to be more pervasive and even destructive ("pervasive and potentially catastrophic" - Scott Plous, The Psychology of Judgment and Decision Making) compared to the many other cognitive biases.

Don't Blink! The Hazards of Confidence by Daniel Kahneman
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