2004: Could you comment on the insanity of the national debt, derivatives, and stock valuations?

AUDIENCE MEMBER: Good morning, gentleman. I’m Neil Steinhoff from Phoenix, Arizona.

Thanks for the tips on TIPS. Also thanks for the information in the newsletter — your annual letter — about the books. I particularly enjoyed “Bull!” by Maggie Mahar, I think it was.

I’m concerned about the future for a number of different reasons, in America. The debt, both accumulated by the government and personally, the stock buybacks, which are benefiting the top five executives, continues. The insanity of derivatives and the overpriced market with a P/E, which is also insane. Any comments?

WARREN BUFFETT: Well, which one do you want us to comment on? You only get one question. (Laughter)

AUDIENCE MEMBER: Derivatives.

WARREN BUFFETT: Derivatives.

Well, Charlie and I have expressed ourselves on derivatives. You know, we don’t think the probability, in any given year, is necessarily very high, that derivatives will either lead to or greatly accentuate some financial trauma. But we think it’s there.

And I think it’s fascinating to look at something like Freddie Mac, where you had an institution that perhaps even hundreds of financial analysts were looking at — certainly many, many dozens of financial analysts were looking at. You had an oversight office. You had a creature that was created by Congress, presumably with committees that would be interested in their activities.

You had on the board two of the smartest and highest-grade people that you could have, in terms of fixed income markets, in Marty Leibowitz and Henry Kaufman, and you had a bunch of other very good directors, too.

And, with an auditor present, they managed to misstate earnings by some $6 billion in a fairly short period of time.

Now, all of that wasn’t accounted for by derivatives, but a very large portion of it — 6 billion, that, you know, that is real money even — well, in any place. A large part of that was facilitated by activities and derivative instruments.

Now you can look at the Freddie Mac annual report for 2000, whatever it is, ’2 or 2001. And you can read the footnotes and you can read the auditor’s certificate. And you can look at bunch of high-class, very smart directors.

And you can be comforted by the fact that dozens of people in Wall Street, who are paid just to follow relatively few stocks, were studying this, and that they had conference calls all of the time.

And in the end, what happened? It was 6 billion. It probably could have been 12 billion if they’d wanted.

A lot of mischief can happen with derivatives. And as we’ve pointed out, Charlie and I have seen it happen.

When there’s a derivative transaction, particularly a complicated one — the plain vanilla ones, probably people will not get in big trouble on — but when you have a complicated derivative transaction, and the trader at investment house A is on one side and a trader on investment house B is on the other side, and they record a transaction — which has to be a zero-sum game between the two of them — and both put on the books a profit that day — I’ve never seen one where they both put on a loss that day — it lends itself to mischief. And the scale is absolutely huge and getting larger all the time.

And I will tell you that I know the managements of some of the companies that have big derivative activities, and they do not have their minds around what is happening.

We didn’t have our mind around what was happening at Gen Re Securities. We couldn’t. We tried to get our mind around it. We couldn’t do it. And that was far from, you know, the most extensive or complicated derivative operation around.

We had the same experience at Salomon. But whatever the figures were at Salomon, they would be a great multiple today. And there was a Sunday in 1991 when we were preparing — or we had the lawyers preparing — bankruptcy papers at Salomon.

And if the Treasury hadn’t reversed itself, we would have found a judge some place in Manhattan. He probably would have been watching baseball, eating popcorn. And we would’ve walked up to his door and said, “You know, here is a situation with Salomon. There’s these 1.2 trillion of derivative contracts that the guy on the other side thinks is good and they’re not going to be any good,” and a lot of other things, and, you know, “It’s your baby.”

A lot of things correlate in the securities world that people don’t expect to correlate. And there are people following similar strategies all over the world, as happened when Long-Term Capital had its problems.

And the world — the financial world — operates on a hair trigger, to some extent. People want to jump the gun and move just ahead of the other fellow.

And when you get huge amounts of transactions, which many people only vaguely understand, you are creating a potential huge problem that may come about because of some other exogenous event that triggers defaults on a huge scale. And that can be very disruptive to financial markets.

So we think they’re dangerous as used in society. We use them ourselves, incidentally. You know, we get them collaterized. We’ve made money off of them.

But I would predict that sometime, in the next 10 years, that you will have some very big problems that will either be caused by, or accentuated in a big way, by people’s activities in derivatives.

Charlie?

CHARLIE MUNGER: Yeah, I think part of the trouble in — you were talking about — came because people didn’t think enough about the consequences of the consequences.

That’s a common error. You start trying to hedge against interest rate changes, which is a very complicated thing to do when you’ve got a mortgage portfolio where people have options to pay the mortgages off early.

And then, under the accounting conventions, the hedges started making the quarterly results lumpy instead of nice and regular, the way all the institutional analysts like them. So then they gave us another bunch of derivatives to smooth out the returns. Well, now you’ve morphed into lying.

Well, it’s complicated enough to start with. But when you add lying to the process, it’s a Mad Hatter’s Tea-Party.

And yet, this happens with eminent directors of vast financial sophistication sitting on the board. It shows that the sophistication won’t save you. Somebody has to have the common sense to say, “We’re just not going there.” It’s too tough.

WARREN BUFFETT: Charlie was on the audit committee at Salomon and changed it into, you know, six and seven hours meetings. I think you found mismarks that were in the tens of millions of dollars on a single contract with a place with many — you know, tens of thousands of contracts. Isn’t that correct?

CHARLIE MUNGER: I think it’s fair to say that it was bonkers and that the accountants sold out.

WARREN BUFFETT: Uh-huh. (Laughter)

It’s interesting stuff. You might — if you feel in kind of a nasty mood, you might go to a shareholders meeting of some company that has very large positions in derivatives and grill the CEO a little bit about some of the more esoteric transactions.

They get very, very complicated. They get mind-boggling, in terms of trying to figure out the consequences.

And the one thing you can be sure of is that the trader that puts them on will certainly want to mark them at a profit, either immediately or within a year or two, because he gets his bonus too often based on the figures for that year, and will be done in 20 years, because some of these are very long-dated. Will be gone — when the consequences fall to the firm.

Anytime you have incentives, with people who are quite smart, to mismark things, you’re going to get mismarks, or temptations to take on risk in an inappropriate manner.

Originally with derivatives, the argument was made that it would disperse risk. That, you know, the Coca-Cola Company faced foreign exchange risk, or some bank faced, you know, interest rate risk.

And the theory was that you would use these derivatives to spread risk around the system. And indeed, there are many people that make that argument now.

I would say that that may work in that manner a great percentage of the time. But the time that counts is when the system has intensified risk and placed enormous credit risk on very, very few institutions.

Believe me, the Coca-Cola Company is in a better position to accept foreign exchange or interest rate risk in a year than some derivatives dealer who has tons of positions on.

And I think, actually, there is much more risk in the system because of derivatives than the proponents of derivatives would say has been dispersed because of the activities.