1995: Does Berkshire use derivatives?

AUDIENCE MEMBER: My name is Maurus Spence from Omaha, Nebraska. I have a two-part question on derivatives.

Does Berkshire Hathaway currently, or had they in the past, engaged in strategies involving derivatives?

If so, do you as CEO, fully understand these financial instruments? (Laughter)

WARREN BUFFETT: Whoever suggested that crazy notion? (Laughter)

AUDIENCE MEMBER: Finally, would Charlie care — you or Charlie — care to comment on the use of these by other financial institutions?

WARREN BUFFETT: The question about derivatives — the reason I inject that remark — in a Fortune article that all of you should read if you haven’t, I suggested that the use of derivatives would be dramatically reduced if the CEO had to say in the report whether he understood them or not, and — (Laughter)

The answer to your question, though, is we have two types, I guess it would be, of derivative transactions, of very modest size. But that doesn’t mean we wouldn’t — if the conditions were right, we either wouldn’t have them on a much greater scale now, or we wouldn’t have done it in the past.

We have two types of transactions, and I do understand them. And there are times when there are things that we would want to do — not often — but there would be times when they could be best accomplished by a transaction involving a derivative security. And we wouldn’t hesitate to do so.

We would obviously care very much about the counterparty, because that transaction is just a little piece of paper between two people. And it’s going to cause one of the two to have to do something painful at the end of the period, usually, which is to write a check to the other person.

And therefore, you want to be sure that that person will be both willing and able to write the check. And so, we’re probably more concerned about counterparty risk than most people might be.

Last year and the year before, I think I said that derivatives often combine borrowed money with ignorance, and that that is a rather dangerous combination. And I think that we’ve seen some of that in the last year.

When you can engage in, sort of, non-physical transactions that involve hundreds of millions, or billions, or tens of billions of dollars, as long as you can get some party on the other side to accept your signature, that really has — that has the potential for a lot of mistakes and mischief.

And if you’ve looked at the formulas involved in some, particularly I guess, interest rate-type derivative instruments, it is really hard to conceive of how any business purpose could be solved by the creation of those instruments.

I mean, they essentially had a huge, really, gambling element to them.

And I use that in the terms of engaging in a risk that doesn’t even need to be created, as opposed to speculative aspects. They involved a creation of risk, not the transfer of risk, you know, not the moderation of risk, but the creation of risk on a huge scale.

And it may be fortunate that in the last year, half a dozen or so cases of people that have gotten into trouble on them have come out because it — that may tend to moderate the troubles of the future.

The potential is huge. I mean, you can do things in the derivative markets —

Well, I’ve used this example before, but in borrowing money on securities, the Federal Reserve of the U.S. Government decided many decades ago that society had an interest in limiting the degree to which people could use borrowed money in buying securities.

They had the example of the 1920s, with what was 10 percent margin. That was regarded as contributing to the Great Crash.

So, the government, through the Fed, established margin requirements and said, “I don’t care if you’re John D. Rockefeller,” you know, “You’re going to have to put up 50 percent of the cost of buying your General Motors stock,” or whatever it may be.

And they said that maybe Mr. Rockefeller doesn’t need that, but society needs that. They don’t — we don’t want a bunch of people on thin margins gambling, you know, essentially, in shares, where the ripple effects can cause all kinds of problems for society.

And that’s still a law. But it means nothing anymore because various derivative instruments have made 10 percent margins of the 1920s, you know, look like what a small-town banker in Nebraska would regard as conservative, compared to what goes on.

So, it’s been an interesting history. You know, like I say, perhaps the experiences of the last year — they’ve got everybody focused on derivatives. Nobody knows exactly what to do about them.

Berkshire Hathaway will — if we think something makes sense and Charlie and I understand it — we may find ways to use them to what we think will be our advantage.

Charlie, you want to add anything on that?

CHARLIE MUNGER: Well, I disapprove even more than you do, which is hard.

If I were running the world, we wouldn’t have options exchanges. The derivative transactions would be about 5 percent of what they are. And the complexity of the contracts would go way down. The clearing systems would be tougher.

I think the world has gone a little bonkers. And I’m very happy that I’m not so located in life that I have to be an apologist for it.

You know, a lot of these people, I feel sorry for them. You know, they had great banks. And they have to go before people, sometimes even including their children and friends, and argue that these things are wonderful.