Buffett’s Partner Charlie Munger in 2005: Derivatives Blowup in Next 5-10 Years

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Charlie
Munger in Poor Charlie’s Almanack,
Expanded Second Edition, 2005-6, pp. 125-128

Warnings About
Financial Institutions and Derivatives

Risks of Financial Institutions

The
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
downfall].

Maybe
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.

We’re
exceptionally goosey of leveraged financial institutions. If they start talking
about how good risk management is, it makes us nervous.

We
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.

Derivatives

The
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.

People
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.

Somebody
has to step in and say, “We’re not going to do it—it’s just too hard.”

I
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.

It’s
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.

When
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.

Derivatives
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.

Nobody
seems to recognize what a disaster of a system they’ve created. It’s a demented
system.

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 about this than
Warren.

Accounting for Derivatives

I
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.

It’s
bonkers, and the accountants sold out. Everyone caved, adopted loose
[accounting] standards, and created exotic derivatives linked to theoretical
models.

As
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.

It
[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.

To
say accounting for derivatives in
America is a sewer is an insult to sewage.

Likelihood of a Derivatives Blowup

We
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.

I’ll
be amazed if we don’t have some kind of significant [derivaties-related] blowup
in the next five to ten years.

I
think we’re the only big corporation in
America to be running off its derivatives book.

It’s
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.”

3 Comments

  1. paulballen

    From AIG’s recent 10Q:
    (http://www.sec.gov/Archives/edgar/data/5272/000095012308008949/y59464e10vq.htm)

    Freestanding Derivatives
    Derivative assets and liabilities can be exchange-traded or traded over the counter (OTC). AIG generally values exchange-traded derivatives using quoted prices in active markets for identical derivatives at the balance sheet date.
    OTC derivatives are valued using market transactions and other market evidence whenever possible, including market-based inputs to models, model calibration to market clearing transactions, broker or dealer quotations or alternative pricing sources with reasonable levels of price transparency. When models are used, the selection of a particular model to value an OTC derivative depends on the contractual terms of, and specific risks inherent in, the instrument as well as the availability of pricing information in the market. AIG generally uses similar models to value similar instruments. Valuation models require a variety of inputs, including contractual terms, market prices and rates, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs. For OTC derivatives that trade in liquid markets, such as generic forwards, swaps and options, model inputs can generally be corroborated by observable market data by correlation or other means, and model selection does not involve significant management judgment.
    Certain OTC derivatives trade in less liquid markets with limited pricing information, and the determination of fair value for these derivatives is inherently more difficult. When AIG does not have corroborating market evidence to support significant model inputs and cannot verify the model to market transactions, the transaction price is initially used as the best estimate of fair value. Accordingly, when a pricing model is used to value such an instrument, the model is adjusted so the model value at inception equals the transaction price. Subsequent to initial recognition, AIG updates valuation inputs when corroborated by evidence such as similar market transactions, third-party pricing services and/or broker or dealer quotations, or other empirical market data. When appropriate, valuations are adjusted for various factors such as liquidity, bid/offer spreads and credit considerations. Such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used.
    With the adoption of FAS 157 on January 1, 2008, AIG’s own credit risk has been considered and is incorporated into the fair value measurement of all freestanding derivative liabilities.

  2. Kash Kirk

    You’re either not smart enough or too lazy to understand something that derives value from something else. It’s hard to tell since you advocate somebody standing up and saying, “we’re too stupid to be doing this, let’s stop…” which could fall either under stupidity or laziness.

    That’s the issue you’re more qualified to be advocating for a solution.

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