2006: What would an actual derivatives meltdown look like?

AUDIENCE MEMBER: Hi. Steve Rosenberg (PH) from Michigan, originally. First, I’d just like to thank you both very much for continuing to serve as role models for integrity and common sense.

Can you describe a little bit more specifically — (Applause) — how a derivatives meltdown might progress and, ultimately, get resolved after it’s been precipitated, and is there a plausible way to resolve it without some sort of a major bailout that would exacerbate a too-big-to-fail moral hazard problem?

WARREN BUFFETT: It’s really hard to tell. I mean, it — you know, it — what will cause people to yell “fire,” what will — how many people will rush for the exits, what they’ll do when they get there — it happens occasionally.

You know, with LTCM — Long-Term Capital Management — in 1998, you know, it affected the financial world in a big way. It didn’t affect it in the biggest way. I mean, the feds stepped in. But there were some pretty — pretty strange things happened during that period, in markets.

What happened in the junk bond market in 2002? I mean, it closed for a while almost, and it was chaos. So it’s very hard to know exactly what would happen. I’ll give Charlie a question here.

In 1991, when we were in Salomon — it was in August, middle of August — and on a Sunday we were within, probably, a half an hour of seeking out a federal judge to turn over the keys to the place to him and go into bankruptcy.

And, fortunately, the Treasury reversed itself, and we got out of that particular predicament. But the law firm was drawing up the papers for bankruptcy.

Now, that was on a Sunday. What would have happened Monday — and we had a good — we had, for those days, a good-sized derivative book. It would be peanuts now, but it was — it looked big at the time. We had a lot of security settlements due the next day.

Now, it happened to be the same day that Gorbachev was spirited away, and the Dow opened down a couple hundred points the next day off of a much lower Dow.

Now, if you had superimposed upon that the fact that Salomon failed in Japan starting at 7 o’clock or so the previous night and that it was — if you were delivering securities to them against payment the next day, you weren’t going to get paid.

And if you were expecting securities from them, you weren’t going to get those securities. And, by the way, you had a — I think a 6- or $700 billion derivative book.

And people who had traded off those derivatives had to try and figure out where they stood and scrambled around and whether their counterparties were any good.

What do you think would’ve happened on that Monday, Charlie?

CHARLIE MUNGER: Well, it could have been absolute chaos. That was a very interesting story with an interesting moral. Nick Brady really prevented that bankruptcy.

And he knew about Berkshire Hathaway from having been a family shareholder with the Chaces way, way back. And that had caused him to follow the matter with interest, particularly since he’d sold his own stock and watched his relatives, the Chaces, hold theirs.

So he knew about us, and I think he trusted you, Warren. And I think that mattered that day. So these old-fashioned reputational —

WARREN BUFFETT: Well, what would have happened the next day? I —

CHARLIE MUNGER: Well —

WARREN BUFFETT: It was terrifying. I’ll put it that way.

CHARLIE MUNGER: Yeah, it was terrifying. And — but there was an element of personal reputation in the avoidance of finding out what would have happened that next day.

WARREN BUFFETT: Kim Chace, who I introduced you to earlier, his father actually introduced me to Nick Brady many, many years earlier, mid ’60s, when Nick was working — was at Dillon Read and Malcom Chace said, “I’d like you to meet” — I guess he was a nephew or grandnephew.

In any event, I went over to Dillon Read and — I would have been in my 30s then — and Nick was a few years older — and we had a good time talking.

And then in 1991, he was secretary of the Treasury. And the Treasury had issued a death sentence to us at 10 o’clock in the morning on Sunday, and, fortunately, Nick, reversed that about 2:30 in the afternoon.

And if he hadn’t, I don’t know what would have happened. But that would have been kind of a pilot case for a mild derivatives daisy-chain-type panic. But that would be nothing compared to something now.

If — now, there’s way more of the stuff that is collateralized these days than formerly, but it would not be a — it’s not an experiment you would want to voluntarily conduct, I’ll put it that way.