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.