Buffett Warned Us in 2003
Warren Buffet foresaw the current financial disaster more than five years ago. I pulled out his 2002 Chairman’s Letter, wherein he addresses derivatives and their potential to scuttle the entire financial system. Here are some key passages:
“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.”
“In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.””
“Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. 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.”
“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. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.”
“In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
There’s much more, available on the Berkshire website. Warren and Charlie have made some additional comments at the 2007 annual meeting (courtesy of Whitney Tilson). Munger:
“As sure as God made little green apples this will lead to big trouble in due time. This will lead to a result we have been expecting for some time.”
On the math models used by Wall Street:
“They’re all crazy.” “Very smart people do very dumb things” and that just because people “have high IQs” does not prevent them from creating financial models that are “at least 50% twaddle.”
On Berkshire’s underwriting standards:
“We only write fire insurance on concrete bridges that are covered by water.”
Buffett:
“Not too many years ahead you will get disruption. Predicting when is something we can’t do…(It will reward) those with cash and guts.”
Munger:
“Will Rogers said, ‘Learn not to pee on an electrified fence without actually doing it.”
Alas, heeding that last one would’ve saved Wall Street many times.
The financial system is built upon leverage. Its very existence depends on lack of correlation - the requirement that bad things don’t all happen at once: that depositors don’t make a run on the bank, insurance liabilities aren’t all claimed at once, derivative contracts don’t all go the same way at the same time, mortgages don’t all default at once. However, as Buffett says and I also heard Bill Ackman paraphrase, when the stuff hits the fan, everything correlates. That’s where we are now.
If you took on too much risk, levered up too much, didn’t prepare for the day when everything correlates… well then adios. See ya. Buh-bye.
Buffett and Munger were not so much prescient as good students of market history and innately conservative. They’d seen it all before in one form or another. I return to Galbraith from his book “A Short History of Financial Euphoria”:
“The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes it distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.”
Obviously Bear, Lehman, Freddie, Fannie, AIG, WaMu, Countrywide, on and on, went with the “lesser adequacy” model.
Disclosure: Long BRK.B
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This article has 21 comments:
- GKM
- 173 Comments
Sep 17 06:06 PM- apppro
- 56 Comments
My Website
Sep 17 06:36 PMThe only thing he can do is have interviews with Becky Quick telling everyone how great, but humble he is; or offer (as he did last year for Ambac) to buy a company for a penny on the dollar. I guess you could argue that in some cases, like Lehman, that would have better off then it is now.
Buffett! Don't get me started!
- DonSuper
- 28 Comments
Sep 17 06:46 PM- GKM
- 173 Comments
Sep 17 07:15 PMhttp://...[see below]
Today we likely broke the long term trend line you see on that chart that was so critical to stay above.
- GKM
- 173 Comments
Sep 17 07:16 PMtinyurl.com/4cnxmk
[SA editor: sorry we can't accommodate long links, we have created a tinyurl for you.]
- glassbox
- 125 Comments
Sep 17 08:33 PMWhat do you get?
A big mess!
- A happy Buffett's follower
- 1 Comment
Sep 17 09:33 PMThen I bought four time BRKB this year. Frankly, it makes me very
happy. I do not understand what Buffett's talking. I do not need to.
There must be a reason if so many people has said he is good for so
many times, for so long. Because he made them happy.
- Nicky
- 2 Comments
Sep 17 10:05 PM- curious cat
- 128 Comments
My Website
Sep 18 02:05 AM1. owners of shares must be allowed to decide whether their shares can be lent to others.
2. short selling should be allowed for people under six feet in height only.
3. no short selling on margin.
4. brokers who go broke must form a support club.
5. no shorting of stocks under five dollars a share. let the people who actually own the friggin stock keep a few bucks, ok?
- Bryanb
- 8 Comments
Sep 18 03:34 AMNicky Sox was created to make it more difficult for company management to steal from shareholders. It seems to have worked, because that is not the problem now. The problem now is that those socialist wimps on Wall Street (previously Capitalist Kings) got too greedy, just like company management did pre-2001. I agree, SOX is onerous, but if derivatives, shorting, etc. had had that kind of oversight and disclosure, then maybe we would have been spared some of this excessive turmoil now.
- WEBISKING
- 173 Comments
My Website
Sep 18 08:10 AM- Utide
- 267 Comments
Sep 18 08:20 AMopportunities to pick up good deals after all the failures of those self-destructed institutions. When he finally comes out to pick up the pieces, he will be called a "HERO."
- TonyC-SA
- 39 Comments
Sep 18 10:20 AMNo business is going to profit from stopping a disease before anybody catches it. We don't want courts or law enforcement to be a pay to play proposition, this creates a caste system where the wealthy are protected by private armies and the poor get screwed. We don't want the sewer and trash to be a profit-oriented operation, or the poor catch and spread disease to all of us.
We don't want schools privatized as profit operations, because we can't hold them accountable until a decade later, after they have taken the money and run.
Businesses engage in short-term R&D that shows a promise of profit; if all research is privatized as for profit operations, basic research grinds to a halt, because the hallmark of **basic** research is we don't know whether it will lead to anything or not, we just want to answer an open question or explore a mystery.
We don't want for-profit enterprises certifying or food is safe, licensing our doctors or lawyers, inspecting our buildings and restaurants or even certifying our drivers, because business would simply be driven to the lowest cost, most corrupt operators imaginable. (Can you spell your name? Okay good, here is your driver's license, and for today's special, here is your license to practice medicine.)
Government is the polar opposite of business. Businesses are psychopathically focused on profit, government is there to provide the counterbalance that keeps businesses from enslaving the population for their own gain.
That in turn is the reason for taxes, you must force businesses to give up a share of the profit to provide this counterbalance, because 95% of them are amoral or immoral and don't give a crap about anything or anyone that doesn't produce a profit.
As for Buffett, half my assets are in BRK.B, there was a brief bubble in it at the beginning of this year but it has returned to its 5 year track of 10.7% return and is undervalued by a few $100 as I write. But I don't think anybody should run the country like a business. That is what got us into the current meltdown.
I don't think the government should be anti-business, we need a balance of for-profit and not-for-profit thinking, and there is a fair level of taxes that isn't socialism. The role of the government is to promote common good, provide security and safety, and ensure businesses aren't exploitive, fraudulent, cooking the books or lying to customers and investors.
- Bonnie
- 10 Comments
Sep 18 10:37 AMWhen several people that I know were trying to help people ready to be foreclosed upon refinance...those institutions wouldn't even pick-up their phones! I know that many mortgage brokers and other concerned groups tried to help advocate on behalf of all of those people now suffering. but These So and So's had made their money and they figured that they would grab up the foreclosures and resell them in a packaged deal to some other group...as they usually do anyway!!!
DID ANYONE START TO MONITOR AND CONTROL?...NO! Do they care that they are having to use more Taxpayer's money to bail them out again...NO!
I wrote to the Federal Reserve a year ago warning of these issues! The response by a person with the initials (they didn't even want to put their name to the email-the coward!) was as follows:
Thank you for your most recent correspondence concerning fiscal policy, an issue outside the Federal Reserve Board's purview.
Please note, that, because of their expertise, the Chairman and the Governors of the Federal Reserve Board are often called on to offer their views on issues that lay outside of the Board's purview. In the case of the government's fiscal policies, responsibility for decisions rests with the Congress and the Administration and not with the Federal Reserve Board. Given your concerns, you may wish to write to the congressperson representing your district. Again, thank you for taking the time to share your views with us. Sincerely, JPD, Board Staff
[edited for excessive ranting and shouting-SA editor]
- notsosmart
- 1049 Comments
Sep 18 12:23 PM- Walkingwounded
- 1 Comment
Sep 18 01:07 PM- ValueInvestor
- 78 Comments
Sep 18 03:24 PMHe has a responsibility to Berkshire's shareholders and if he "helped" out like you're saying he would have done nothing but harm them.
- Chris B
- 319 Comments
Sep 18 05:14 PMThat said I have to admire the man for the philanthropic act of passing on the wisdom to this generation.
- mkreisel
- 266 Comments
Sep 18 11:43 PMIt seems nobody understands what great deals those Buffett index puts are! Well, written puts backed up by cash is nothing but well-paid limit buy orders! They are only dangerous if one's buying can't cover the entire liabilities.
- GKM
- 173 Comments
Sep 18 11:57 PMThanks to the SA Editor for the link change over.
- Getridofthemnow
- 25 Comments
Sep 19 01:44 PM