2016: How does Buffett analyze banks?

AUDIENCE MEMBER: Good morning Mr. Buffett and Mr. Munger. My name’s Adam Bergman. I’m with Sterling Capital in Virginia Beach.

In your 2008 shareholder letter, you said, “Derivatives are dangerous… They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks.”

So my question for you is: how do you analyze and value companies like Bank of America Merrill Lynch and other commercial banks that Berkshire has investments in, relative to their significant derivative exposures? Thanks.

WARREN BUFFETT: Yeah, derivatives do complicate the problem very dramatically.

Now, they are moving away to being collateralized, which helps.

But there’s no question that if you asked me to describe the derivative position of the B of A, for example, I would know that they have done a conscientious job and worked hard at properly evaluating.

But the great danger in derivatives is if there’s a discontinuity. If there’s not discontinuities, you probably don’t have much of a problem, assuming they get marked to market, and collateralized, and so on.

But if the system stopped for a while — the system stopped after 9/11 for three or four days. It stopped at the time of World War One. They closed the New York Stock Exchange for many months.

They debated closing the stock exchange, very seriously, the day after October 19, 1987. And it was — there were a lot of people that wanted to close it. And on that Tuesday morning, it looked like it was about to stop, but it continued.

But if you had a — if you have a major cyber, nuclear, chemical, biological, attack on the country — which will certainly happen at some point — if you have a major discontinuity, then you’ll have a lot of problems, a lot of problems.

But you will also — when things reopen — you will find there can be enormous gaps in things that you thought were fully protected by collateral, and that sort of thing, or netting arrangements, and that type of thing.

So I regard very large derivative positions as dangerous.

We inherited a modest- sized position at Gen Re and, in a benign market, we lost about $400 million, just in trying to unwind it, with no pressure on us whatsoever.

So I do think it continues to be a danger to the system.

CHARLIE MUNGER: By the way, the accountants blessed that big derivative position as being worth a lot of money. They were only off, what, many hundreds of millions.

WARREN BUFFETT: Yeah, well. Charlie found one position when he was on the audit committee at Salomon. I think it was mismarked by $20 million.

I actually, by happenstance, happen — I do know of one incredibly mismarked position — doesn’t affect any of our operations — but it almost staggers the mind to know the way that position is marked. And you can only come to the conclusion that some trader got somehow — influenced whoever did mark it, or marked it himself, heaven forbid, and probably just influenced someone.

Or they didn’t know enough. Some of these things get so complicated, they are very hard to evaluate. That’s the kind that have the most profit in them, usually, so they were quite enthusiastic about those when we were at Solomon.

They can be extraordinary hard to mark. And, like I say, I know one that’s so mismarked it would blow your mind.

And, you know, the auditors, I don’t think, are necessarily capable of holding that behavior in check.

It’s very interesting, because now there’s really four big auditing firms, and obviously, they’re auditing companies where there’s a derivative position, and they’re auditing company A that’s on one side of the transaction, and they’re auditing company B that’s on the other side of the transaction. In some cases, it’s the same auditor.

And I will guarantee you that there’s plenty of times when the marks on what they’re attesting to are significantly different, which would be an interesting exercise to pursue, in terms of checking those numbers out.

Derivatives are still dangerous, in large quantities, and we have — we would not do them, on a collateralized basis, because if there was a discontinuity, I don’t know exactly where we would end up, and I’m never going to get us in a position where we could have money demanded of us and not be able to fulfill it with ease, and with me sleeping well.

So we won’t engage in it. We’ve got some in runoff, but so far we’ve made money and had the use of money for a decade or more, and it’s been very attractive for us. But that does not entice me, at all, into doing any derivative transactions that would involve collateral, when collateral is not required.

It’s still a potential time bomb in the system.

Anything where discontinuities — and basically that means closing up and stopping trading markets from functioning — anything where discontinuities can exist, can be real poison in markets.

Kuwait, some years ago, went to a very delayed system on settlement of stock purchases, so they didn’t have to settle up for six months or thereabouts. And it caused all kinds of problems, because, you know, you’ve got an IOU from somebody for six months and if you got zillions of those, a lot of trouble can ensue.

So I agree with your general caution. I’m not in the least troubled by our Bank of America investment, nor our Wells Fargo — we added to Wells Fargo — and our Bank of America position, right now, is a preferred stock, but we’re very likely to exercise the warrants on that.

On the other hand, there are a great number of banks in the world. If you take the 50 largest banks in the world, we wouldn’t even think about probably 45 of them. Wouldn’t you say that, Charlie?

CHARLIE MUNGER: Well, we’re in the awkward position where I think we’ll probably make about $20 billion out of derivatives, and just those few contracts that you and Ajit [Jain] did years ago.

All that said, we’re different from the banks. We would really prefer it if those derivatives had been illegal for us to buy. It would have been better for our country.