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Derivatives – An epidemic for society; and a Personal update

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I will describe how derivates are a grave danger to society with an example from keen edged Munger.

WB : Warren Buffett
CM : Charlie Munger

Let alone the foregone fact that survival of those institutions is at stake which use leverage and derivatives, it also encourages a dishonest behaviour in society.

A simple Example :

Assume Cravatex Ltd outsources shoes from a manufacturer, assume Relaxo Ltd. There would be times when Cravatex is not going to pay cash instantly to the supplier i.e. Relaxo. In books of account of Cravatex if there is 5 Crores pending as in liabilities section dues to Relaxo Ltd, then in latters books there is 5 Crores in assets/ recoverables. If two auditors were to compare books of accounts it would Zero out. Therefore in toto, it balances out in society.

A non simple (Derivative) example:

When long lasting derivatives bets are undertaken that will come to fruition after 10 or 50 years, each party optimistically assumes that the likely possibility of its bet turning in favour is higher. Therefore if Party A and Party B have a bet against each other, they are likely to even out in 2030 when bet settles. But as of 2010 i.e. today if Party A is showing 1 million $ profits on derivatives contract, Party B is not showing 1 Million $ loss in book, thus overrating profits in short run. The total is not matching up. Auditors are not responsible as of today to cross check other organisations’ accounts. This results in inflated profits motivated in increased commissions for those who inititated contract.

What the two young men have to say ?

Your opinion on derivatives?

WB : Charlie and I think that there is a low but not insignificant probability that at some time — I don’t know when; it could be three years, it could be 20 years — derivatives could lead to a major problem. The problem grows as derivatives get more complex. We hoped to give a mild wakeup call to the financial world that there’s a problem. In the energy sector, derivatives destroyed or almost destroyed institutions that shouldn’t have been destroyed. [He mentioned Enron.]
Charlie and I would not know how to regulate it. We have some experience seeing specific dangers in that field and some insight into systemic problems that can arise. People don’t want to think about it until it happens, but it is best thought about before it happens.
It’s a low probability, but we think a lot about low probability events. We have some experience with Salomon and Gen Re. Charlie saw some things on Salomon’s audit committee [that were very risky/questionable].

[CM: In engineering, people have a big margin of safety. But in the financial world, people don’t give a damn about safety. They let it balloon and balloon and balloon. It’s aided by false accounting. I’m more pessimistic than Warren. I’ll be amazed if we don’t have some kind of significant blowup in next 5-10 years.

Derivatives are advertised as shedding risk for the system, but they have long crossed the point of decreasing risk and now increase risk.

The truth is that Coca Cola could handle risk (currency exposure)[I think he was talking about currency exposure], but now with every company transferring risk to very few players, they are all hugely interdependent. Central banks are exposed to weaknesses. If Salomon had failed, the problems for the rest of the system could have been quite significant. When you start concentrating risk in institutions that are highly leveraged, [watch out]. They have big trading departments with people who make a lot of money.
It’s not a prediction, it’s a warning.

  • Source: BRK Annual Meeting 2003 Tilson Notes
  • Time: 2003
It’s fascinating to look at a company like Freddie Mac: an institution that dozens of financial analysts were looking at; that had an oversight office; that was created by Congress with committees to oversee it; that had two smart, exceptional board members, Marty Leibowitz and Henry Kaufman; and that had auditors present – yet Freddie misstated earnings by $6 billion in a short time. That’s big money. And a large part of it was facilitated by derivatives. You can go back and read the footnotes, listen to the conference calls, etc. and you wouldn’t have known. In the end, it was $6 billion, but it could have been $12 billion if they’d wanted.
Derivatives can lead to a lot of mischief. When you have a complicated derivative transaction, and a trader with investment house A on one side and investment house B on the other side, and on the day the deal is done, both record a profit, this can lead to mischief – and the scale is getting bigger every day.
I know the managements of many large financial institutions and they don’t have their minds around this. We tried at Gen Re [where we had a small derivative book] and couldn’t.
Whatever problems there were at Salomon [during its crisis years ago], they’re far, far worse now [systemwide].

In 1991, if the government hadn’t reversed himself [in its plans to take actions that would have put Salomon out of business], we were preparing documents [to file for bankruptcy. Had this happened,] We had $1.2 trillion [notional value] of derivative contracts that others were counting on, that would have gone bad. All sorts of securities transactions wouldn’t have settled, accounts in Japan and the UK would have been affected, etc. For instance, Salomon had a relationship with a bank in Germany which took large deposits in Germany and lent the money to Salomon. All kinds of things would have come out. You don’t need to put these strains on a system that’s already highly leveraged.

When you get huge amounts of transactions, which not many people understand, you create a huge problem that may be triggered by an exogenous event.

We use derivatives – we get them collateralized – and we’ve made money on them. But I predict that sometime in the next 10 years, we will have a big problem caused by or exaggerated by derivatives.

[CM: People don’t think about the consequences of the consequences. People start by trying to hedge against interest rate changes, which is very difficult and complicated. Then, the hedges made the results [reported profits] lumpy. So then they use new derivatives to smooth this. Well, now you’ve morphed into lying. This turns into a Mad Hatter’s Party. This happens to vast, sophisticated corporations.
Somebody has to step in and say, “We’re not going to do it — it’s just too hard.”

If you want to have a little fun, go to the annual meeting of a big financial company and ask about the details of a complex transaction. They won’t know – but you can be sure the trader who did it will be well paid for it.

Any time you have situation where smart people can make money by taking risk, you’ll get it.

Q – How dangerous are derivatives to the financial system and what can be done to mitigate potential damage from them?

We’ve tried to mitigate it [raise warning flags about the dangers of derivatives] a little by talking about it, but realize there is nothing inherently evil about derivatives. We have at least 60 of them and will be discussing them at our upcoming Berkshire board meeting.

Derivatives are expanding rapidly, in more and more imaginative ways. They introduce invisible leverage into the system. In the 1930s, after the crash, the government concluded that leverage contributed to the crash and that it was dangerous. So the U.S. government empowered regulators to deal with this. For decades, they policed it and it was taken seriously when the Fed increased or decreased margin requirements.
But the introduction of derivatives has made any regulation of margin requirements a joke. The regulation still exists, but it’s an anachronism.

I believe that we may not know when it becomes a super danger or when it will end precisely, but I believe it will go on and increase until very unpleasant things happen because of it.
You saw one example of what can happen under forced sales in October 1987. It was driven by portfolio insurance, which was a joke. It was a bunch of stop/loss orders, but done automatically, and it was merchandized. People paid a lot of money for people to teach them how to put in a stop/loss order. When a lot of institutions do this, the effect is pouring gas on a fire. They created a doomsday machine that kept selling and selling.

You can have the same thing today because you have fund operators with billions of dollars – in aggregate, trillions of dollars – who will all respond to the same stimulus. It’s a crowded trade, but they don’t know it and it’s not formal. They will sell for the same reasons. Someday, you will get a very chaotic situation.
As for what could trigger this and when, who knows? Who had any idea that shooting an archduke would start Word War I?

CM: The accounting being enormously deficient contributes to the risk. If you get paid enormous bonuses based on profits that don’t exist, you’ll keep going. What makes it difficult [to stop] is that most of the accounting profession doesn’t realize how stupidly it’s behaving. One person told me the accounting is better because positions are marked to market and said, “Don’t you want real-time information?” I replied that if you can mark to market to report any level of profits you want, you’ll get terrible human behavior. The person replied, “You just don’t understand accounting.”

WB: When we went to close out Gen Re’s derivatives book, we took a $400 million loss on a portfolio that was “marked to market” by the prior management and auditors – and I’m not criticizing our auditor. Any auditor would have said the same. I wish I could have sold to the auditors instead!
Take a dry cleaning business that owes $15. Their books show a $15 accounts payable and the other company shows an offsetting $15 accounts receivable. But there are only four big auditing firms, so in many cases, if they’re auditing my side, the same firm may be valuing or attesting to the value of what’s on the books of the person on the other side. I will guarantee you that if you add up the marks on both sides, they don’t add up to zero. We have 60 or more derivative contracts, and I’ll bet the other side isn’t valuing them like we are. I have no reason to mark the value up – we don’t get paid for that. If I value it at $1 million on our side, the other side should be marking it at minus $1 million, but I guarantee the numbers are widely different. Auditors should check both sides of derivative trades and the “marks” should sum to about zero. They don’t.

CM: As sure as God made little green apples, this will cause a lot of trouble. This will go on and on, but eventually will cause a big denouement.

  • Source: BRK Annual Meeting 2007 Tilson Notes
  • Time: 2007
Q: What useful function do derivatives serve? Why aren’t derivatives illegal?

WB: Charlie may have more to comment.

CM: The usefulness of derivatives is overstated. We’d still have oats and wheat if we didn’t have derivative markets. The test is not ‘is there any benefit’, but is the NET benefit or disadvantage useful or better without. My own view is that if we had only [exchange traded] [Ed: another notetaker heard: agriculture and metals] and banned the rest – the world would be better place.

WB: BNSF has diesel contracts. If I was running the place, I wouldn’t hedge – unless you are smarter than the market in diesel fuel. If you are you shouldn’t be running a railroad, you should be run a diesel trading business. If you have someone in charge of running that hedge, they will hedge it. If he thinks that will make him a better manager of railroads, then fine, let him do it, but I will hold CEO responsible for running it over time. I wouldn’t condemn anyone for hedging diesel fuel. But I do think if you put up (slide4) – from Chapter 12 of Keynes General Theory – it is by far the best description of the way capital markets function. It is descriptive and prescriptive. Usually only the first two sentences are quoted, but it is better as a whole paragraph:

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism – which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

Wall Street is mix of casino and a very important social operation – and once academia got behind derivatives and schools taught more about how to price a derivative instead of valuing a business, the trouble began. In 1982 Wall Street allowed speculation in SP500 futures. I wrote letter to Congressman Dingle which was published in Fortune Magazine. What I forecasted occurred then it got squared, with new ways to gamble.

CM: Warren wrote the only letter saying the idea is insane. Only difference is then not very many people listened to him.

WB: It doesn’t make any sense that the tax treatment on gambling on S&P 500 contracts is better (partial long term capital gains treatment) than buying and holding individual stocks for less than a year (SP500 contract is taxed 60% long-term gain and 40% short term, even if you hold it for 60 seconds). This distortion came about as a result of the power of a small group of lobbyists. Charlie do you know why this is?

CM: It is neither fair nor sensible. The idea that the tax treatment on something that is held for 3 seconds is different than something that is held for less than a year (some long term gains treatment for the former and none for the latter) is insane. If someone with money and interest cares a lot and others are indifferent, that someone wins in front of the legislative bodies. As Bismarck said, don’t watch sausage making or law making.

  • Source: BRK Annual Meeting 2010 Boodell & Claremon Notes
  • Time: 2010

What are your views on derivatives and how do you think they have affected the global market?

In my 2002 letter to shareholders I referred to them as “weapons of mass destruction.” Derivatives are really just a way to create a product with a very long fuse, for example, 100 years, as opposed to stocks which settle in 3 days. That kind of system allows claims to be built up. AIG called me in September and told me they were about to get downgraded which would have required higher posting requirements. Now this is an enterprise that has been built up over decades and was effectively destroyed in 48 hours by these products. With derivatives, you’re exposed to counterparties and thus reliant on others. These claims built up over time to the tune of billions of dollars and when one falls, the whole system falls. Derivatives are not evil by themselves but rather everyone needs to be able to handle them. System wide, they’re rat poison. Berkshire holds many derivatives but we always hold the money at Berkshire. 

  • Source: Q&A with 6 Business Schools
  • Time: Feb 2009

Personal Update

I have been putting in over 40 hours a week on equity research besides the day job for the last few years now and its become my pet mania. Actually I believe I have been putting in more hours than that. It does not feel like work since I have enjoyed the process and learning, consequences of the process often pleasant and sometime painful were welcome too.

I realize than 95%+ of you who read blogs actively must enjoy the process of investing and I hope to continue to inspire those who enjoy the freedom that material wealth brings. However, there are those of us who do not like investing process or like to delegate that work to others have alternative of funds or investing partnerships.

Personally, I am tired of logging into Kotak, Indiainfoline, other Brokerages accounts of my relatives, in laws, close friends who are passive investors and have left everything for me to manage. I manage my personal money separate from theirs, infact they all have separate brokerage, bank, trading accounts and it has reached a stage where I cannot manage all accounts effectively.

I am consulting a CA to open partnership to consolidate all holdings for any new money. Once I am happy in next few weeks/months and have sorted out details and modus operandi, I would like to extend this to a handful of other people, since this is what I intend to do for next few years. Currently I have way too many ideas relative to funds, fortunately I am not in Buffetts position whose idea pool is starved relative to fund size.

I do realize that people feel more comfortable to invest their hard earned money with established fund houses or squander a few thousand bucks at tipsters for offering stock advice rather than parting their money to potential fly by night operators or Ponzi mafias. This is why I want to continue with a select coterie of friends who trust me and I do not want to belong to either mentioned category earlier. I’d be happy with accepting only a couple prospective friends per year or none at all, it suits me since I do not want the model to be scalable. 

Another reason is that I do not want to bite more than I can chew. Third reason is that excess capital can weigh down returns. I only want to attract a select few who do not want to touch the money for 3-5 years and redeem money once a year. I would accept interest in partnership only once a year. Needless to say, there is no entry or exit load unlike mutual funds. I would charge fee based on performance and high watermark only on returns in excess of certain threshold per annum, it would be same for my uncles, friends or parents in law.

This also implies that historically any stock that I have so far mentioned to everyone including relatives has been done so at same day and time would no longer be done so. Since my personal funds would be invested in partnership I’d like to buy before declaring publicly. Thus, I would have a vested interest in every stock I mention. I would choose to not disclose parts of holding publicly or to partners as well. I would be open for annual Audits and surprise Audits including those by any one at all including Big Four should my partners choose to. 

As always anyone who likes investing is encouraged to do personal research before making purchase decision and also ignore my opinion, everyone has one !  I would typically invest depending on opportunities, 15% in Microcaps like the ones I have mentioned on this blog for the past one year, 25% in Mid Caps and 50% or in Large Caps and some cash.  The ratio can change in extremely wild swings and mass available opportunities. Hence, please do your due diligence before making purchase decision. My fortunes should swing with yours and I would like to avoid any conflict of interest by putting my 100% of my holding in partnership unlike Fund Managers do, they all have personal account which is often front run before fund account. There would be no personal account after a year once I get out of taxation on existing positions.

Anything I say should be cross checked, neither my partnership nor I take any personal guarantee on authenticity of what is said. I or my partnership will have no liability for what is written and published on this blog. More details later. 

Written by amitdipsite

December 15, 2010 at 4:17 am

Posted in Uncategorized

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