Buffet vs RG
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Mosaic ImmunoEngineering is a nanotechnology-based immunotherapy company developing therapeutics and vaccines to positively impact the lives of patients and their families.
Message: Why the 5% additional dilution since the 10K filing?!
years ago, Buffet says:
Derivatives
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.
Having delivered that thought, which I’ll get back to, let me retreat to explaining derivatives, though
the explanation must be general because the word covers an extraordinarily wide range of financial contracts.
Essentially, these instruments call for money to change hands at some future date, with the amount to be
determined by one or more reference items, such as interest rates, stock prices or currency values. If, for
example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives
transaction – with your gain or loss derived from movements in the index. Derivatives contracts are of
varying duration (running sometimes to 20 or more years) and their value is often tied to several variables.
Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the
creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the
counterparties record profits and losses – often huge in amount – in their current earnings statements without
so much as a penny changing hands.
The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it
seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years
in the future, were put on the books. Or say you want to write a contract speculating on the number of twins
to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.
When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie
and I didn’t want, judging it to be dangerous. We failed in our attempts to sell the operation, however, and
are now terminating it.
But closing down a derivatives business is easier said than done. It will be a great many years before
we are totally out of this operation (though we reduce our exposure daily). 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.
Another commonality of reinsurance and derivatives is that both generate reported earnings that are
often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates
whose inaccuracy may not be exposed for many years.
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. But often there is no real market (think about our contract involving twins) and “mark-to-model”
is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving
multiple reference items and distant settlement dates increase the opportunities for counterparties to use
fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use
differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model
degenerates into what I would call mark-to-myth.
Of course, both internal and outside auditors review the numbers, but that’s no easy job. For
example, General Re Securities at yearend (after ten months of winding down its operation) had 14,384
contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus
value derived from one or more reference items, including some of mind-boggling complexity. Valuing a
portfolio like that, expert auditors could easily and honestly have widely varying opinions.
The valuation problem is far from academic: 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.”
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.
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.
Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay
off much of their business with others. In both cases, huge receivables from many counterparties tend to
build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a
liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit
exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous
event that causes the receivable from Company A to go bad will also affect those from Companies B through
Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more
tranquil times.
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. That’s how
we conduct our reinsurance business, and it’s one reason we are exiting derivatives.
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.
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.
Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term
Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue
effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the
trades of LTCM – a firm unknown to the general public and employing only a few hundredpeople – could
well have posed a serious threat to the stability of American markets. In other words, the Fed
acted because its leaders were fearful of what might have happened to other financial institutions had the
LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for
weeks, was far from a worst-case scenario.
One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate
100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts
up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a
future date it will receive any gain or pay any loss that the bank realizes.
Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of
derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the
risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and
analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with
derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities
of major banks, the only thing we understand is that we don’t understand how much risk the institution is
running.
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. Knowledge of how dangerous
they are has already permeated the electricity and gas businesses, in which the eruption of major troubles
caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business
continues to expand unchecked. Central banks and governments have so far found no effective way to
control, or even monitor, the risks posed by these contracts.
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.
Hopefully RG has the same kind of wisdom.
2 Recommendations
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