Tuesday, March 15, 2011

Buffet on derivatives

Transcript of Buffet's recent interview with the Financial Crisis Inquiry Commission.

NYTimes: ... “If I look at JPMorgan, I see two trillion in receivables, two trillion in payables, a trillion and seven netted off on each side and $300 billion remaining, maybe $200 billion collateralized,” he said, walking through his thinking. “That’s all fine. But I don’t know what discontinuities are going to do to those numbers overnight if there’s a major nuclear, chemical or biological terrorist action that really is disruptive to the whole financial system.”

“Who the hell knows what happens to those numbers?” he asked. “I think it’s virtually unmanageable.”

Mr. Buffett defended Berkshire Hathaway’s use of derivatives, arguing that the company maintains a limited amount. At the time of the interview, the company had only about 250 derivative contracts. (It’s now down to 203.) “I want to know every contract, and I can do that with the way we’ve done it. But I can’t do it with 23,000 that a bunch of traders are putting on.”

... when Berkshire bought General Re in 1998, the reinsurance company had 23,000 derivative contracts. “I could have hired 15 of the smartest people, you know, math majors, Ph.D.’s. I could have given them carte blanche to devise any reporting system that would enable me to get my mind around what exposure that I had, and it wouldn’t have worked,” he said to the government panel. “Can you imagine 23,000 contracts with 900 institutions all over the world with probably 200 of them names I can’t pronounce?” Berkshire decided to unwind the derivative deals, incurring some $400 million in losses.

... Perhaps the most insightful nugget in the interview was Mr. Buffett’s explanation of why corporations use derivatives — and why they probably shouldn’t.

Many companies, as diverse as Coca-Cola and Burlington Northern, argue that they employ derivatives to hedge their risk. The United States-based Coca-Cola tries to protect against fluctuations in currencies since it does business around the world. Burlington Northern, the railroad giant, uses the investments to limit the impact of fuel prices.

Mr. Buffett, who has interests in both companies, claimed there was another agenda. “The reason many of them do it is that they want to smooth earnings,” he said, referring to the idea of trying to make quarterly numbers less volatile. “And I’m not saying there’s anything wrong with that, but that is the motivation.”

The numbers all even out eventually, he cautioned, so derivatives don’t really make much difference in the long term.

“They’re going to lose as much on the diesel fuel contracts over time as they make,” he said of Burlington Northern. “I wouldn’t do it.”

My very first post (2004) on this blog was about Fannie Mae's use of derivatives accounting to smooth earnings.


Kim_Dae-jung said...

The numbers all even out eventually, he cautioned, so derivatives don’t really make much difference in the long term.

This is not true for very leveraged businesses, like the family farm, and like Fannie Mae. When earnings are assured even if their expectation is reduced more leverage can be taken on and production increased. JPMorgan being a bank is another necessarily very leveraged business.

Derivatives and insurance may give the illusion of reducing risk in an absolute sense when all they can do is make it more uniform.

LondonYoung said...

The "Financial Crisis Inquiry Commission", a.k.a. "The Angelides Commission" run by Phil Angelides, who was appointed by Barack Obama to "study" the crisis. So, what was Mr. Angelides job before this? How'd he do at it? The wikipedia reveals all.

If memory serves, Mr. Buffet refused to talk to him unless he was subpoenaed, so serve him Mr. Angelides did.
I think it speaks very poorly of the president that he would grant a guy like this subpoena power, or any power, to "explore", in the name of the American people, a financial crisis.

David said...

It makes me laugh how this works out. It's always the quites versus the not-quites in the regulatee-regulator game.

LondonYoung said...

Angelides wasn't even really a regulator or a regulatee, just a guy with control of public funds seeking his own personal political gain. So a "not-not-quite". At least with TARP the US govt is getting all its money back. Good luck to California.

Kim_Dae-jung said...

Should regulators make a GS salary?

LondonYoung said...

I would suggest whatever wage keeps qualified applicants in equilibrium with available job slots.

Nicolas Rolland said...

Yeah, let's admit the numbers even out.
Which manager wants his result be impacted by a bad year.
So you come to me and give me a fee, I even you things out.

Nicolas Rolland said...

seriously, though, may be he is notwrong. but one can say this of every financial transaction : in the end it evens out. actually it is the basis of financial calcultaion "fair price". insurance ? it evens out...

Tim Giangiobbe said...

They are giving the investors what they want.
They want Collateral Debt Obligations,GO FIGURE !
The Banks are giving out ZILCH so they take risks.
It's the HOT SHOTS bribing someone to rate BBB at AAA and thinking it will not be an issue as long as everyone gets paid.

Old School Ethical Players aren't what screwed it up.The Youngsters wanting to change a culture to get ahead is what SCREWS THINGS UP.The Weeding Out of the HOT SHOTS will fill a few cells in Federal Prison before this is over.
Risk is OK as long as everything is disclosed!
Like the fact that they bribed a ratings official.

The Issue isn't Capitalism.

Tim Giangiobbe said...

Warren sees the HOT SHOTS and can't tell them a damn thing.They are all on their OWN PROGRAM.The Finacial Capers are many the SEC only has so much resources.The small time player may never get caught.
The Ones that grab enough to make a go at a small business or have an extra nest egg and then stop at a few hundred thousand are more than then public realizes when it come to insider trading and are never caught.

That is where greed takes over and they can't stop.
Just can't imagine being that stupid after having enough to be comfortable.

city0880 said...

thanks for share......

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