One Thought Regarding Derivatives from the Annual Letter

[zarley]

From the shareholder letter:

 

Indeed, recent events demonstrate that certain big-name CEOs (or former CEOs) at major financial institutions were simply incapable of managing a business with a huge, complex book of derivatives. Include Charlie and me in this hapless group: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.”

 

and a little further down . . .

 

A normal stock or bond trade is completed in a few days with one party getting its cash, the other its securities. Counterparty risk therefore quickly disappears, which means credit problems can’t accumulate. This rapid settlement process is key to maintaining the integrity of markets. That, in fact, is a reason for NYSE and NASDAQ shortening the settlement period from five days to three days in 1995.

 

Derivatives contracts, in contrast, often go unsettled for years, or even decades, with counterpartiesbuilding up huge claims against each other. “Paper” assets and liabilities – often hard to quantify – become important parts of financial statements though these items will not be validated for many years. Additionally, a frightening web of mutual dependence develops among huge financial institutions. Receivables and payables by the billions become concentrated in the hands of a few large dealers who are apt to be highly-leveraged in other ways as well. Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with.

 

This portion of the derivatives discussion made me wonder just how much money Buffett and Munger saved Berkshire by exiting General Re's derivatives business when they did. Buffett notes that the costs at the time were $400 million in losses, and that was in a functioning market for derivatives. How many billions in losses would have been incurred had they not taken the actions that they did, and instead had to deal with these contracts in the market of 2008?

 

In addition to being a cautionary tale about the risks of derivatives, it's a reminder that the decisions they make today will be paying off for Berkshire many years down the road. At the time they were exiting the General Re derivatives business, booking $400 million in losses looked like a giant mistake on Buffett's part. From today's perspective that $400 million loss looks a lot better; it saved Berkshire billions.

 

zarley