Munger on Derivatives

Some excerpts from an interview with Charlie Munger in the spring 2009 edition of the Stanford Lawyer:

On Unlimited Leverage
"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. When they wanted to make the securities market function better as a gambling casino with vast profits for the people who were croupiers—there was a big constituency in favor of dumb change. Buffett was like a man trying to stop an elephant with a pea shooter. We're not controlling financial leverage if we have option exchanges. So these changes repealed longtime control of margin credit by the Federal Reserve System."

"Unlimited leverage comes automatically with an option exchange. 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."

"Our regulators allowed the proprietary trading departments at investment banks to become hedge funds in disguise, using the 'repo' system—one of the most extreme credit-granting systems ever devised. The amount of leverage was utterly awesome."

On Bringing Back the 'Bucket Shop'
"Interest rate swaps have enormous dangers given their size and the accounting that has been allowed. But credit default derivatives took that danger to new levels of excess—from something that was already gross and wrong. In the '20s we had the 'bucket shop.' The term bucket shop was a term of derision, because it described a gambling parlor. The bucket shop didn't buy any securities. It just enabled people to make bets against the house and the house furnished little statements of how the bets came out. It was like the off-track betting system."

"Derivatives trading, with no central clearing, brought back the bucket shop, because you could make bets without having any interest in the basic security, and people did make such bets in the billions and billions of dollars. Some of the most admired people in finance — including Alan Greenspan — argued that derivatives trading, substituting for the old bucket shop, was a great contribution to modern economic civilization. There's another word for this: bonkers. It is not a credit to academic economics that Greenspan's view was so common."

The complete interview, from back in spring 2009, is definitely well worth reading. There are some excellent insights and, as always, Munger's manner of speaking is no-nonsense.

Munger's emphasis has always been on an interdisciplinary education and that becomes obvious the more you read and listen to him. He started as a student of math and physics before getting a law degree and starting his law firm Munger, Tolles, & Olson.

Then, of course, came his business career.

He's also self-taught on a whole range of subjects some that he can often explain better and in a whole lot more useful manner than what you'll find in academia.

Adam

Related post:
Buffett on Derivatives