2003: How did Buffett's Fortune article come about?

AUDIENCE MEMBER: Good morning. I’m Whitney Tilson, a shareholder from New York City.

There was a lot of talk among the Berkshire faithful when you took what I believe was the unprecedented step of pre-releasing a portion of your annual letter, published in Fortune, which focused primarily on the dangers of derivatives — which you called “financial weapons of mass destruction.”

I have two questions related to this — the first to you, Mr. Buffett.

Could you tell us the story of how the Fortune article came about? Were you trying to draw extra attention to something that you feel strongly is a great risk to our financial system?

And the second question to both of you, since you’re warning about derivatives, there’s been a huge rally in the credit markets, in general. Does this reflect investors’ lack of concern for these systemic risks or is it caused by other factors?

WARREN BUFFETT: The first question, my friend [Fortune Magazine journalist] Carol Loomis is the editor of the Berkshire report. And we wouldn’t get out the report without her. I mean, she is the world’s greatest editor, in addition to being the world’s greatest business writer.

So when I gave the report to her to edit — and it did not come back unmarked, I might add — she and I talked about — I mean, I was interested in having the section on derivatives because I thought it had a broader — I hoped it would have a broader audience than just the Berkshire annual report.

And I felt that publishing it, which had no relationship to the Berkshire business, basically, except the history of Gen Re’s involvement, would not be, in any way, compromising fair disclosure, in terms of Berkshire’s results itself.

So the primary reason for having it in Fortune was I hoped for a wider audience, basically, by having it in Fortune.

And you know, Charlie and I think there is a low, but not insignificant, probability — and low — that sometime, maybe in three years, maybe in five years, maybe in 20 years, and very possibly never, that derivatives could accentuate, in a major way, a systemic problem that might even arise from some other phenomenon.

And we think that’s inadequately recognized. We think the problem grows as derivatives get more complex and as their usage increases.

So it was a call — what we hope was a mild wakeup call — to the financial world that these things could be very troublesome.

And of course, we saw it in the energy field in the last two years. It almost destroyed, or destroyed certain institutions that never should have been destroyed.

And the — we also saw, in 1998, the whole financial system almost become paralyzed, particularly in the credit markets, you know, by the action of a firm, which was not solely based on derivatives, but would not have gotten into as much trouble as it did without derivatives.

So it’s a subject that no one quite knows what to do with. Charlie and I would not know how to regulate it, but we think we have had some experience in seeing both the firm’s specific dangers in that field, and we think we have some insight into the systemic problems that could arise.

And you know, that people really — they don’t want to think about it until it happens. But there are some things in the financial world that are better thought of before they happen, even if they’re low probabilities.

And we’re thinking about low probabilities all the time, in terms of Berkshire. I mean, we don’t want anything to go wrong in a big way at Berkshire. And we therefore, I think, think about things that a good many people don’t think about — simply because we worry about that.

And when we get our social hats on we think about it in terms of something like derivatives for financial systems of the world. And we have had some experience at both Salomon and at Gen Re.

And Charlie was on the audit committee at Salomon, and he saw some things in the audit committee in relationship to trading itself, and derivatives in particularly, that made him wonder why in the world people were doing these sort of things. I’ll let Charlie expand on that.

CHARLIE MUNGER: Yeah, in engineering, people put big margins of safety into systems — atomic power plants being the extreme example. And in the financial world, in derivatives, it’s as though nobody gave a damn about safety.

And they just let it balloon, and balloon, and balloon in usage, and number of trades, and size of trades.

And that ballooning is aided by this false accounting, where people are pretending to make money they’re not really making.

I regard that as very dangerous, and I’m more negative than Warren in the sense that I’ll be amazed, if I live another five or 10 years, if we don’t have some significant blow-up.

WARREN BUFFETT: They’ve been advertised, and sometimes in a fairly prominent way — they’ve been advertised as shedding risk for participants in the system, and reducing risk for the system.

And I would say that I think they have long crossed the point where they decrease risk to the system, and now they enhance risk. Because you have — the truth is, the Coca-Cola Company couldn’t bear the foreign exchange risk that they run, or the interest rate risk that they run, and all of that sort of thing.

But when the Coca-Cola Company starts laying those off, and every other company in the world — major company — does with just a relatively few players, you have now intensified the risk that exists in the system.

You have not shed risk at all, you have transferred it, and you have transferred it to very few players. And those players have huge interdependencies with each other, and to some extent, central banks and all of those similar institutions are vulnerable to the weaknesses of those institutions.

When Charlie and I were at Salomon, you know, they hated it if we brought up — and so therefore, we didn’t do it — that we were too big to fail.

But the truth was that if Salomon failed at that time, the problems for the rest of the system could well have been significant. They might’ve been — who knows exactly what they would have been? But they could have been quite significant.

And when you start concentrating risks in institutions which are highly leveraged, and who intersect with a few other institutions like that — all bearing same risks, all having the same motivations in the trading departments — to take on more and more esoteric things because they can book more and more immediate profits, you are courting danger.

And that’s why I wrote about it this time. And I — it’s not a prediction, it’s a warning.