1999: What are your thoughts on the collapse and bailout of Long Term Capital Management? (Part 2)

This is the second part of the answer to question about the collapse of LTCM. You can read part one here.

WARREN BUFFETT: It’s interesting. If you read that report, which is put together by these four very imminent bodies, I think on the first page, it says that the first so-called hedge fund — which is a term generally applied to entities like LTCM — first hedge fund was set up in 1949.

And I probably read that or heard that 50 times in the last — particularly in the last year. And of course, that’s not true at all, and I’ve even pointed this out once or twice before.

But Ben Graham had — and Jerry Newman — had a classical hedge fund back in the ’20s. And I worked for — I worked dually for a company called Graham-Newman Corp, which was a regulated investment company and Newman and Graham, which was an investment partnership with, I think, a 20 percent participation in profits and exactly the sort of entity that, today, is called a hedge fund.

So, if you read anyplace that the hedge fund concept originated in 1949, presumably with A.W. Jones, it’s a — it’s not an accurate history. There are now — I ran something that would generally be called a hedge fund. I didn’t like to think of it that way. I called it an investment partnership. But it would’ve been termed a hedge fund. Charlie ran one from about, what, 1963 to mid ’70s or thereabouts.

And they have proliferated in a big way. Did he blink? (Laughter)

There are now hundreds of them. And of course, it’s very enticing to any money manager to run, because if you do well, or even if you don’t do so well but the market does well, you can make a lot of money running one.

This report that just came out has really nothing particularly harsh to say about the operation.

So, I think you will see hundreds and hundreds and hundreds of hedge funds. I think the current issue of Barron’s may have a recap of how a large group did in the first quarter.

And there’s a lot of money in those funds. And there’s a huge incentive to form them. And there’s a huge incentive to go out and attract more money if you run one. And when that condition exists in Wall Street, you can be sure that they won’t wither away.

Charlie?

CHARLIE MUNGER: Yeah, what was interesting about that one is how talented the people were. And yet, they got in so much trouble. I think it also demonstrates that — I’d say, the general system of finance in America involving derivatives is irresponsible.

There’s way too much risk in all these trillions of notational value sloshing around the world. There’s no clearing system, as there is in a commodities market. And I don’t think it’s the last convulsion we’re going to see in the derivatives game.

WARREN BUFFETT: It’s fascinating, in that you had 16 extremely bright — I mean, extremely bright — people at the top of that. The average IQ would probably be as high or higher than organization you could find, among their top 16 people.

They individually had decades of experience and collectively had centuries of experience in operating in these sort of securities in which the LTCM was invested. And they had a huge amount of money of their own, up. And probably a very high percentage of their net worth in almost every case, up.

So here you had superbright, extremely experienced people operating with their own money. And, in effect, on that day in September, they were broke. And to me, that is absolutely fascinating.

There was book written,”You Only Have to Get Rich Once.” It’s a great title. It’s not a very good book. Walter Gutman wrote it, but it — many years ago. But the title is right, you only have to get rich once.

And why do people, very bright people, risk losing something that’s very important to them, to gain something that’s totally unimportant? The added money has no utility whatsoever.

And the money that was lost had enormous utility. And on top of that, reputation is tarnished and all of that sort of thing.

So that the gain/loss ratio, in any real sense, is just incredible. I mean, it’s like playing Russian roulette.

I mean, if you hand me a revolver with six bullets — or six chambers — and one bullet and you say, “Pull it once for a million dollars,” and I say, “No.” And then you say, “What is your price?” The answer is there is no price.

And there shouldn’t be any price on taking the risk when you’re already rich, particularly, of failure and embarrassment and all of that sort of thing. But people repeatedly do it. And they do it —

Whenever a bright person, a really bright person, goes broke that has a lot of money, it’s because of leverage. It — you simply — you basically can’t — it would be almost impossible to go broke without borrowed money being in the equation.

And as you know, at Berkshire, we’ve never used any real amount of borrowed money. Now, if we’d used somewhat more, you know, we’d be really rich. But if we’d used a whole lot more, we might have gotten in trouble some times. And there’s just no upside to it, you know?

What’s two percentage points more, you know, on a given year, that year? And run the risk of real failure. But very bright people do it, and they do it consistently, and they will continue to do it.

And as long as explosive-type instruments are out there, they will gravitate toward them. And particularly, people will gravitate toward them who have very little to lose, but who are operating with other people’s money.

One of the things, for example, in the LTCM case — and Charlie mentioned it in terms of derivatives — in effect, there were ways found to get around the — and they were legal, obviously — to get around the margin requirements.

Because risk arbitrage is a business that Charlie and I have been in for 40 years in one form or another. And normally, that means putting up the money to buy the stock on the long side and then shorting something against it where you expect a merger or something to happen.

But through derivatives, people have found out how to do that, essentially putting up no money, just by writing a derivative contract on both sides. And there are margin requirements, as you know, that the Fed promulgates that, I believe, still call for 50 percent equity on stock purchases.

But those requirements do not apply if you arrange the transaction in derivative form. So that these billions of dollars of positions in equities, essentially, were being financed a hundred percent by the people who wrote the derivative contracts. And that leads to trouble.

You know, 99 percent of the time it works. But, you know, 83 and a thirds percent of the time, it works to play Russian roulette with one bullet in there and six chambers. But neither 83 1/3 percent or 99 percent is good enough when there is no gain to offset the risk of loss.

Charlie?

CHARLIE MUNGER: I would argue that there is a second factor that makes the situation dangerous. And that is that the accounting for being actively engaged in derivatives, interest rate swaps, et cetera is very weak. I think the Morgan Bank was the last holdout.

And they finally flipped to a lenient standard of accounting that’s favored by people who are sharing in the profits from trading derivatives. And that’s why they like liberal accounting.

So, you get an irresponsible clearing system, irresponsible accounting — this is not a good combination.

WARREN BUFFETT: JP Morgan shifted their accounting — I think — I’m not sure exactly when — around 1990. But Charlie and I, we probably became more familiar with that when we were back at Salomon.

And this is absolutely standard. You know, it’s GAAP accounting. But it front-ends profits. And if you front-end profits and you pay people a percentage of the profits, you’re going to get some very interesting results, sometimes.