Excerpt from Mr. Buffett's 2002 Letter to the Shareholders of Berkshire Hathaway that is worth reviewing in light of recent market developments:
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 outstanding trades of LTCM - a firm
unknown to the general public and employing only a few hundred people -
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.
