2008: Are the risks at investment banks too complicated for anyone to manage?

AUDIENCE MEMBER: My name is Ola Larson (PH). I live in Salt Lake City. And I think — on Lou Rukeyser, Wall Street Week, 1981 or something. So you must really have impressed me, Warren.

What I’d like to ask you is that looking at the future, have the business practices of the investment banks become so complex that it is not possible for the head of the investment bank to be aware of the exposures to financial risks day-to-day or week-to-week?

WARREN BUFFETT: Yeah. That’s an exceptionally good question, and I think the answer, probably, is yes, at least in some places, although there’s a few investment bank heads I’ve got enormous respect for their ability to sort of get their minds around risk.

But I decided, for example, when we bought Gen Re, it had about 23,000 derivative contracts, and I think I could have spent full time on that and not really been able to get my mind around how much risk we could — we were running — under some fairly extreme conditions that I did not think were impossible, but that the people who were running the operation might have thought were impossible, or that might not have cared about it that much because their own incentive compensation was such that if they made a lot of money one year on something, it would work 99 years out of a hundred, they would feel the chances of something going wrong big were very slim.

But I don’t want to have it slim. I want to have it none. So I regard myself as the Chief Risk Officer at Berkshire.

If something goes wrong at Berkshire because of — in terms of risk — of the way we run the place, there’s no way I can assign that to a risk committee or have some mathematicians come in and make a bunch of calculations and tell me I’m only running a risk that will happen once in the history of the universe or something of the sort.

I think the big investment banks, a number of them — and big commercial banks — I think they’re almost too big to manage effectively from a risk standpoint in the way they’ve elected to conduct their business.

And it’s going to work most of the time. So you don’t see the risk in a way that — I mean, you don’t — if you have a 1 in 50-year risk that a place will go broke, it may not be in the interest of a 62-year-old executive that’s going to retire at 65 to worry too much about that.

I worry about everything at Berkshire. So I would say they’re too — they’re very hard to manage, very hard to have your mind around. I mean, clearly, you’ve seen cases in the last year where very big institutions, if the CEO knew what was going on, he certainly hasn’t admitted it subsequent to what’s happened.

It’s embarrassing either way, but it’s less embarrassing to say I didn’t know what was going on than to acknowledge that you knew these kind of activities were going on and you let them go on.

It’s — I’ve been asked for advice on regulation sometimes, and we’ve seen an extraordinary example, which somehow the press really hasn’t picked up on much.

But you had an organization called OFHEO whose sole job was to supervise two big companies, and these big companies were Fannie Mae and Freddie Mac.

And they had a large element of public purpose in them, and they were chartered by the federal government, and they had — their activities had overtones for the whole mortgage and securities markets.

So Congress said, “If we’re going to give you all this ‘too big to fail’-type protection, in terms of the federal government stepping in and giving you special privileges, we want to keep an eye on you.”

So they formed OFHEO and they had 200 people going to work, I presume at 9 o’clock every morning, and going home at 5, and their sole job was to see what these two places were doing. And they turned out to be two of the biggest accounting misrepresentations in the history of the world.

So they were two for two with the only things they had to examine. And I fear that if you tried to do the same thing with the biggest commercial banks or the biggest investment banks, I’m not sure you can keep track of it.

What you need is somebody at the top whose DNA is very, very much programmed against risk. And he is going to have to resist the entreaties of those who work beneath him who say everybody else is doing it, and if they can do it over there and make all this money doing it, why can’t we be doing it here?

And that’s not easy to do. When you’ve got a bunch of high-powered people who are used to making in seven figures every year, and they want to do things and they say, “If you don’t do them here, we’re going to go elsewhere,” it’s a very tough system to be.

So I would say that, in many ways, there are firms that, in terms of risk, are simply — they are conducting themselves in a way that they’re too big to manage.

And if at the same time the government says they’re too big to fail, that has some very interesting policy implications.

Charlie?

CHARLIE MUNGER: Well, I would argue that you say that very well. It does have interesting policy implications.

It’s crazy to have people get so big and so important that you can’t allow them to fail, and allow them to be run with as much knavery and stupidity as permeated the major investment banks.

It’s not that Berkshire hasn’t had wonderful service from investment banking all these years, because we have. It’s just that, as an industry, this crazy culture of greed and overreaching and overconfidence in trading algorithms and so on creeps in.

I would argue it’s quite counterproductive for the country, and it ought to be reigned way back.

These institutions are too big to fail, and it was demented to allow derivative trading to end up the way it’s ended up and with the current risks that are embedded in the present system.

And it’s amazing how few people spoke against it as it was happening. There was just so much easy money to be reported.

A lot of the money that was reported as being earned wasn’t really being earned. It was in that wonderful category of assets that I call “good until reached for.”

They sit there on the balance sheet, and when you reach for it, it just fades away like — (laughter)

WARREN BUFFETT: He’s not kidding.

CHARLIE MUNGER: — mist.

WARREN BUFFETT: He’s not kidding.

CHARLIE MUNGER: We had 400 million of that “good until reached for” assets we got with General Re.

WARREN BUFFETT: And they were behaving honorably.

CHARLIE MUNGER: Yes. But at any rate, people pushed it way too far.

In the drug business, they say, “Prove that this works” before they certify the drug.

On Wall Street, they start believing in the tooth fairy, and if one guy is reporting a lot of money, why, everybody else is asking, “Why aren’t we betting on the tooth fairy?”

It’s a crazy culture, and to some extent it’s an evil culture, and it needs a huge reigning in.

And the accounting profession utterly failed us. The worst behaving were the people who set the accounting practice standards. And they’re very bureaucratic and take forever, and they don’t want to do anything real difficult that displeases people.

This is not a combination of wonderful qualities when your job is to set accounting standards, which ought to be dealt with sort of like engineering standards. And they don’t even have the right approach. So there’s a lot wrong.

WARREN BUFFETT: When Charlie and I first got to Salomon, we noticed that they were trading with Marc Rich, who had fled the country. And we suggest — well, we told them — we wanted to quit trading with Marc.

And they said, well, they were making money doing it one way or another, and they said, what the hell did we know about crude oil trading, and they wanted to keep trading with him.

And only by just total directive could we stop our own employees from trading with Marc Rich.

Now, if you can’t stop your people trading with Marc Rich, you know, when you’re focusing on it, just imagine what goes on, you know, in those trading rooms elsewhere.

It’s — if Bear Stearns — I think the Fed did the right thing by stepping in on Bear Stearns.

If Bear Stearns had failed on Sunday night — and it would have — they would have walked over to a federal judge and handed him a bankruptcy petition, I guess, a little after 6 o’clock Midwest time, because that’s when Tokyo opened.

If they had failed, the next day, as I understand it, they had about 14 1/2 trillion — which isn’t as bad as it sounds — but 14 1/2 trillion of derivative contracts.

Now, the parties that had those contracts that had a claim against Bear Stearns would have been required, I think, almost by the contracts they signed, but they would have been required to undo those contracts very promptly to establish the damages they would have against the bankrupt estate.

Just imagine thousands of counterparties around the world, you know, trying to undo contracts, everybody knowing they had to undo contracts in a very, very short period of time.

The 400 million we tried to reach for and didn’t find — we had the luxury of spending about four or five years unwinding those contracts. These people would have had four or five hours to do the same thing with everybody else doing it simultaneously.

It would have been a spectacle that would have been of, I think, of unprecedented proportions, and, of course, it would have resulted, in my view, of another investment bank or two going down, you know, within a matter of days.

Because nobody has to lend you money. In fact, that was one of the interesting things that was said at the testimony when they called them down to the Senate Finance Committee.

They — I think two of the witnesses said, we didn’t understand — we understood we couldn’t borrow money unsecured, if people started looking at us with askance, but they said, we didn’t dream we couldn’t borrow money secured.

Well, we’d found that out at Salomon that we were having money borrowing money secured 17 years earlier.

When the world doesn’t want to lend you money, ten basis points doesn’t do much, you know, or 20 basis points, or 50 basis points much, or a bigger haircut on collateral.

If they (don’t) want to lend you money, they don’t want to lend you money. And if your dependent on borrowed money every day, you have to wake up in the morning hoping the world thinks well of you.

And there was a period there a few months ago when I think every investment bank in the United States was plenty worried about whether people were going to think well of them the next morning.