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Munger in Poor Charlie’s Almanack,
Expanded Second Edition, 2005-6, pp. 125-128
Financial Institutions and Derivatives
Risks of Financial Institutions
nature of a financial institution is that there are a lot of ways to go to hell
in a bucket. You can push credit too far, do a dumb acquisition, leverage
yourself excessively—it’s not just derivatives [that can bring about your
it’s unique to us, but we’re quite sensitive to financial risks. Financial institutions make us nervous when they’re trying to do well.
exceptionally goosey of leveraged financial institutions. If they start talking
about how good risk management is, it makes us nervous.
fret way earlier than other people. We’ve left a lot of money on the table
through fretting. It’s the way we are—you’ll just have to live with it.
system is almost insanely irresponsible. And what people think are fixes
aren’t really fixes. It’s so complicated I can’t do it justice here—but
you can’t believe the trillions of dollars involved. You can’t believe the
complexity. You can’t believe how difficult it is to do the accounting. You
can’t believe how big the incentives are to have wishful thinking about values
and wishful thinking about ability to clear.
don’t think about the consequences of the consequences. People start by trying
to hedge against interest rate changes, which is very difficult and
complicated. Then, the hedges make the [reported profits] lumpy. So then
they use new derivatives to smooth this. Well, now you’ve morphed into lying. This
turns into a Mad Hatter’s Tea Party (where normal use of words…begin to
make no sense ). This happens to vast, sophisticated corporations.
has to step in and say, “We’re not going to do it—it’s just too hard.”
think a good litmus test of the mental and moral quality at any large
institutions [with significant derivatives exposure] would be to ask them, “Do
you really understand your derivatives book?” Anyone who says yes is either
crazy or lying.
easy to see [the dangers] when you talk about [what happened with] the energy
derivatives—they went kerflooey. When [the companies] reached for the assets
that were on their books, they money wasn’t there.
it comes to financial assets, we haven’t had any such denouement, and the
accounting hasn’t changed, so the denouement is ahead of us.
are full of clauses that say if one party’s credit gets downgraded, then it has
to put up collateral. It’s like margin—you can go broke [just putting up more
margin]. In attempting to protect themselves, they’ve introduced instability.
seems to recognize what a disaster of a system they’ve created. It’s a demented
engineering, people have a big margin of safety. But in the financial world,
people don’t give a damn about safety.
let it balloon and balloon and balloon. It’s aided by false accounting. I’m
more pessimistic about this than Warren.
Accounting for Derivatives
hate with a passion GAAP [Generally Accepted Accounting Principles] as applied
to derivatives and swaps. JP Morgan sold
out to this type of accounting to front-end reserves. I think it’s a disgrace.
bonkers, and the accountants sold out. Everyone caved, adopted loose
[accounting] standards, and created exotic derivatives linked to theoretical
a result, all kinds of earnings, blessed by accountants, are not really being
earned. When you reach for the money, it melts away. It was never there.
[accounting for derivatives] is just disgusting. It is a sewer, and if I’m
right, there will be hell to pay in due course. All of you will have to prepare
to deal with a blowup of derivative books.
say accounting for derivatives in America is a sewer is an insult to sewage.
Likelihood of a Derivatives Blowup
tried to sell Gen Re’s derivatives operation and couldn’t, so we started
liquidating it. We had to take big markdowns. I would confidently predict
that most of the derivative books of [this country’s] major banks cannot be
liquidated for anything like what they’re carried on the books at. When the
denouement will happen and how severe it will be, I don’t know. But I fear the
consequences could be fearsome. I think there are major problems, worse than in
the energy field, and look at the destruction there.
be amazed if we don’t have some kind of significant [derivaties-related] blowup
in the next five to ten years.
think we’re the only big corporation in America to be running off its derivatives book.
a crazy idea for people who are already rich—like Berkshire—to be in this business. It’s a crazy business for big banks to be in.
“You would be disgusted
if you had a fair mind and spent a month really delving into a big derivative operation.
You would think it was Lewis Carroll [author of Alice’s Adventures in Wonderland]. You would think it was
the Mad Hatter’s Tea Party. And the false precision of these people is just
unbelievable. They make the worst economics professors look like gods.
Moreover, there is depravity augmenting the folly. Read the book F.I.A.S.C.O.,
by law professor and former derivatives trader Frank Partnoy, an insider
account of depravity in derivative trading at one of the biggest and
best-regarded Wall Street firms. The book will turn your stomach.”
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