2001: How does Buffett think about Berkshire's derivative positions?
AUDIENCE MEMBER: Bill Graham (PH) from Los Angeles. Warren, you’ve made it possible for outside shareholders to understand Berkshire’s financial businesses. But there is one that seems, to me anyway, hard to understand: the financial products business, which I guess involves trading derivatives. Given the concerns you and Charlie have expressed about financial businesses, can you help us understand why you’re comfortable with it?
WARREN BUFFETT: Well, I think you put your finger on it, Bill. It is a hard business to understand—hard even if you own it, let alone reading about it in someone else’s annual report.
I’d guess that most CEOs of companies with extensive derivatives businesses don’t fully understand them. How many lose sleep over that, I don’t know.
At Berkshire, the financial products business includes multiple components. There’s General Re Securities (formerly General Re Financial Products, or GRFP), our structured settlement business, and some fixed-income trading I personally oversee. The structured settlement business is straightforward and predictable, and my fixed-income arbitrage activities are under my direct control.
However, it’s fair to say that neither Charlie nor I fully understand the intricacies of the derivatives operations. That’s why we place so much trust in Mark Byrne, who runs that segment. Mark is both smart and trustworthy, and there’s no one we’d feel more comfortable with managing these operations. But even so, derivatives are not a natural fit for us.
CHARLIE MUNGER: Some of this mix includes Warren’s “oddball pastimes” outside the common stock field. (Laughter) I’m comfortable with those, though the results will likely be irregular. The same applies to Mark Byrne’s own “oddball” personal ideas.
But as for the more standardized derivatives trading businesses, I like them a lot less than most people in the field do.
WARREN BUFFETT: Quite a bit less. (Laughter)
CHARLIE MUNGER: Yes.
WARREN BUFFETT: We view parts of this area as potentially dynamite. Often, employees in derivatives businesses are compensated based on front-ending potential profits—essentially paying people upfront for deals whose outcomes may not be known for 15-20 years. That creates a dangerous dynamic, as some individuals may "crack" under the temptation to inflate numbers.
We saw this happen in the electric utility sector a few years ago, when a California subsidiary compensated employees based on the projected profitability of deals. Predictably, that led to trouble.
If you’re interested in the risks of this business, I’d recommend reading Roger Lowenstein’s When Genius Failed, which highlights some of the problems that make Charlie and me uneasy.
CHARLIE MUNGER: The derivatives business suffers from improper accounting practices, too. The accounting profession has failed the wider civilization by allowing income to be front-ended excessively. This irresponsible system creates inflated compensation, which is part of the broader problem.
WARREN BUFFETT: At Salomon, Charlie served on the audit committee, and we found mismarked single positions off by nearly $20 million.
CHARLIE MUNGER: Deliberate mismarkings were not even the main issue. The core problem is that the accounting system itself is fundamentally flawed—too optimistic. It’s like starting a taxi business with a 30-year depreciation schedule.
WARREN BUFFETT: Or writing long-tail insurance and paying huge upfront commissions based on optimistic projections prepared by the person who wrote the policy.
These practices are inherently risky. At Berkshire, Mark has implemented a more conservative accounting system than industry norms, which we’re thankful for. However, it’s hard to deviate too far from those norms and still do business effectively.