The old man has been proved right once again.
As I’ve watched the mess on Wall Street unfold over the past few days, I can’t help but think back to my earlier career as a financial reporter, more specifically, to the warnings Warren Buffett delivered about derivatives — the complex financial instruments that are playing a central role in the current market crisis.
While the housing market was booming and derivatives were all the rage on Wall Street, it was Buffett who said they were a “time bomb, both for the parties that deal in them and the economic system” and he dubbed them “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Back in May of 2004, I made the trek to Omaha, Nebraska, to cover the annual meeting of Buffett’s holding company, Berkshire Hathaway. Unlike most annual meetings, which are tedious affairs featuring slide presentations and a series of pre-written speeches by top executives, Berkshire functions more like the corporate equivalent of a town hall meeting. Buffett and his longtime partner, Charlie Munger, sit behind a table and spend a day answering questions from the roughly 20,000 shareholders and admirers in attendance.
That prior year had seen Freddie Mac rocked by a scandal resulting from its failure to properly account for the value of its investments in derivatives (which was only a tiny precursor to its more recent problems).
Buffett seized on the news to deliver a lecture on the danger of such investments, noting the fact that Freddie was a company overseen by a board of directors, the U.S. Congress, and a separate regulatory body, and yet nobody was able to get a handle on them. And he informed the crowd that even the CEOs whom he knew didn’t understand the investments.
“I know the people that run these companies and they don’t have their minds around what is happening,” he said.
And then Buffett predicted: “Some time in the next 10 years, you will have a huge problem that will either be caused by or accentuated by people’s activities in derivatives.”
THE HOUSING CRISIS that started by affecting a small number of subprime loans has now triggered the collapse or takeover of some of the biggest names in the mortgage industry (Countrywide Financial, Fannie Mae and Freddie Mac) and three of the top five U.S. investment banks (Bear Stearns, Lehman Brothers, and Merrill Lynch). And last night, the Federal Reserve initiated an $85 billion bailout of insurance giant American International Group (AIG).
It gets to be a chicken in the egg argument as to whether the availability of these new and ever more creative financial instruments caused the housing bubble, or if the expansion of the housing market created more demand for more of these types of investments. But either way, it’s pretty clear that the instruments helped accentuate the problem by fostering the easy money-lending environment in which mortgage brokers were able to pump up sales by granting mortgages to borrowers with patchy credit.
The derivative market served a useful function by allowing banks to bundle loans and to sprinkle different parts of the risk among investment firms, which is one reason why as chairman of the Federal Reserve, Alan Greenspan posited that the benefits of derivatives outweighed the costs. But unfortunately, by spreading the risk around so widely in ever more complex ways, financial firms lost sight of what they actually owned, and became overleveraged.
Conservatives aren’t generally fans of Buffett, now 78, because he’s a loyal Democrat who has advocated higher taxes, and this year, is supporting Barack Obama. But there’s still room to admire Buffett’s strength of conviction when it comes to investing, and his application of his simple Midwestern common sense to complex financial matters.
Even though he’s the richest man in the world according to Forbes, with a net worth of about $62 billion, Buffett still lives in a modest house in Omaha that he purchased in 1958 and maintains a small office in the city. Though he’s a numbers whiz, Buffett built a lot of his fortune making long-term investments in classic American companies, including American Express, Gillette, and Coca-Cola.
His success as an investor has been as much about knowing when to stay away from the latest fads as it is about when to buy, and he refuses to invest in things he doesn’t comprehend. During the Internet boom, some dismissed Buffett as a dinosaur, because wouldn’t put his money in companies when he didn’t understand how they could make a profit. When that bubble burst in 2000, he was vindicated, and revived his reputation for prescience that earned him the nickname “The Oracle of Omaha.”
BUFFETT’S CONCERNS about derivatives were heightened when Berkshire purchased the large insurer General Re in 1998, and he had to spend years merely trying to close down a derivatives business that came with the deal, because of the difficulty of untangling the web of transactions.
Looking back, what’s amazing about Buffett’s warnings on derivatives is not merely that he said they could be dangerous — many others did — but that the scenarios he spoke of were eerily similar to what we’re witnessing today.
AIG faltered because in addition to its regular insurance operations, the company owned a massive amount of credit default swaps, which insure large bondholders against the risk of default. As a result of rising defaults stemming from the housing crisis, AIG suffered tremendous losses, leading to a dwindling stock price and Monday’s downgrades by the major ratings agencies. Collapsing under the weight of huge collateral obligations, the company was forced into the arms of the Fed, which will take an 80 percent stake in what was once the world’s largest insurer.
Back in his 2002 annual letter to his shareholders (which was written in February of 2003), Buffett theorized:
Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.
On Tuesday, as AIG fought for its life, shares of Buffett’s Berkshire Hathaway rose more than 4 percent.