2007: How much bigger could the derivatives market get?

AUDIENCE MEMBER: Yes. Hi, Mr. Buffett and Mr. Munger. This is Whitney Tilson, a shareholder from New York.

For many years both of you have been warning about the dangers of derivatives, at one point calling them “financial weapons of mass destruction.”

Yet every year, tens of trillions of dollars of derivatives are bought and sold. It just seems to be getting bigger and bigger and almost certainly improperly accounted for.

And so I was wondering if you could comment, and, specifically, if you have any thoughts on how much longer this might go on.

Do you see anything imminent that could derail this ever inflating bubble? What might trigger it? And who should be doing what to try and mitigate this looming danger?

WARREN BUFFETT: Well, we’ve tried to do a little to mitigate it ourselves by talking about it, but the — you’re right, the — and it isn’t the derivative itself. I mean, there’s nothing evil about a derivative instrument.

As I mentioned, we have 60-some of them at Berkshire, and on Monday I’ll go over with the directors — I’ll go over all 60-some and, believe me, we’ll make money out of those particular instruments.

But they — usage of them on an expanding basis, more and more imaginative ways of using them, introduces, essentially, more and more leverage into the system.

And it’s an invisible — or largely invisible — sort of leverage. If you go back to the 1920s, after the crash, the United States government held hearings.

They decided that leverage — margin, in those days, as they called it — leverage contributed to, perhaps, the crash itself and certainly to the extent of the crash. And it was like pouring gasoline on a fire was — when people’s holdings got tripped, you know, when stocks went down 10 percent people had to sell, another 10 percent, more people had to sell and so on.

Leverage was regarded as dangerous and the United States government empowered the Federal Reserve to regulate margin requirements, regulate leverage, and that was taken very seriously.

And for decades it was a source of real attention. I mean, if you went to a bank and tried to borrow money on a stock, they made you sign certain papers as to — that you weren’t in violation of the margin requirements, and they policed it.

And it was taken quite seriously when the Fed increased or decreased margin requirements. It was a signal of how they felt about the level of speculation.

Well, the introduction of derivatives and index futures, all that sort of thing, has just totally made any regulation of margin requirements a joke.

They still exist and, you know, it’s an anachronism.

So I believe — I think Charlie probably agrees with me — that we may not know where, exactly, the danger begins and where — and at what point it becomes a superdanger and so on.

We certainly don’t know what will end it, precisely. We don’t know when it will end, precisely.

But we probably — at least I believe — that it will go on and increase to the point where at some point there will be some very unpleasant things happen in markets because of it.

You saw one example of what can happen under forced sales back in October 19, 1987, when you had so-called portfolio insurance.

Now, portfolio insurance — and you ought to go back and read the literature for the couple years preceding that. I mean, this was something that came out of academia and it was regarded as a great advance in financial theories and everything.

It was a joke. It was a bunch of stop-loss orders which, you know, go back 150 years or something, except that they were done automatically and in large scale by institutions and they were merchandise.

People paid a lot of money to people to teach them how to put in a stop-loss order. And what happened, of course, was that if you have a whole series of stop-loss orders by very big institutions, you are pouring gasoline on fire.

And when October 19th came along, you had a 22 percent shrink in the value of American business, caused, essentially, by a doomsday machine. A dead hand was selling as each level got hit. And three weeks earlier, you know, people were proclaiming the beauty of this.

Well, that is nothing compared — it was a formal arrangement to have these — this dynamic hedging or portfolio insurance — sell things.

But you have the same thing existing when you have fund operators operating with billions in aggregate, trillions of dollars, leveraged, who will respond to the same stimulus.

They have what we would call a “crowded trade,” but they don’t know it. It’s not a formal crowded trade.

It’s just that they’re all ready to sell if a certain given signal or a certain given activity occurs. And when you get that, coupled with extreme leverage which derivatives allow, you will someday get a very, very chaotic situation.

I have no idea when. I have no idea what the exogenous factor — I didn’t know that shooting some archduke, you know, would start World War I, and I have no idea what will cause this kind of a thing, but it will happen.

Charlie?

CHARLIE MUNGER: Yeah. And, of course, the accounting being deficient enormously contributes to the risks.

If you get paid enormous bonuses based on reporting profits that don’t exist, you’re going to keep doing whatever causes those phony profits to keep appearing on the books.

And what makes that so difficult is that most of the accounting profession doesn’t even recognize how stupidly it is behaving.

And one of the people in charge of accounting standards said to me, “Well, this is better, this derivative accounting, because it’s mark-to-market, and don’t we want current information?”

And I said, “Yes. But if you mark-to-model, and you create the models, and your accountants trust your models, and you can just report whatever profit you want as long as you keep expanding the positions bigger and bigger and bigger, the way human nature is, that will cause terrible results and terrible behavior.”

And this person said to me, “Well, you just don’t understand accounting.” (Laughter.)

WARREN BUFFETT: If four years ago, or whenever it was, when we started to liquidate Gen Re’s portfolio, we had reserves set up for in the hundreds and millions and all sorts of things.

And our auditor — and I emphasize any other of the Big Four auditors absolutely would have attested to the fact that our stuff was mark-to-market.

You know, I just wish I’d sold the portfolio to the auditors that day. (Laughs) I’d be 400 million better off.

So it’s a real problem. Now there’s one thing that’s really quite interesting to me. If I owe you, on my dry cleaning bill or something, $15, and they’re auditing the dry cleaners, they check with me and they find out that I owe you $15 and it’s all fine.

If they’re auditing me, they find out I owe the dry cleaner 15 bucks. There are only four big auditing firms, you know, basically in this country.

And I will — so in many cases, if they’re auditing my side of the derivative transaction, you know, what I’m valuing it at, the same firm may often be valuing — or attesting to the value of the mark by the person on the other side of the contract.

I will guarantee you that if you add up the marks on both sides, they don’t equate out to zero.

We have 60-some contracts, and I will bet that people are valuing them differently on the other side than we value themselves, and it won’t be to the disadvantage of the trader on the other side.

I don’t get paid based on how ours are valued, so I have no reason to want to game the system. But there are people out on the other side that do have reasons to game the system.

So if I’m valuing some contract at plus a million dollars for Berkshire, that contract on the other side, it’s just one piece of paper, should be valued at a minus 1 million by somebody else.

But I think you probably have cases — and this is — I’m not talking about our auditors, I’m talking about all four of the firms — but they have many cases where they are attesting to values that — of the exact same piece of paper — where the numbers are widely different on both sides.

Do you have any thoughts on that, Charlie?

CHARLIE MUNGER: Well, I — as sure as God made little green apples, this is going to cause a lot of trouble in due course.

As long as it keeps expanding and ballooning and so on and the convulsions are minor, it can just go on and on. But eventually there will be a big denouement.