Mr. Buffett, in a two-hour interview transcribed by the newsletter Santangel’s Review, touched on everything from ratings agencies to the dangers of leverage.
But the most provocative moments centered on derivatives, the complicated investments at the heart of the financial crisis. It is perhaps the first time that Mr. Buffett has opened up so publicly about the topic.
Mr. Buffett once described derivatives as “financial weapons of mass destruction.” Yet some of his most ardent fans have quietly raised eyebrows at his pontifications, given that he plays in the opaque market. In the fourth quarter alone, Berkshire made $222 million on derivatives. TheStreet.com published a column last spring with the headline: “Warren Buffett Is a Hypocrite.”
His comments, which were released last month by the financial crisis commission, come as the government is writing rules for derivatives as part of the Dodd-Frank financial regulatory overhaul. And the statements could influence the debate.
Mr. Buffett appeared to backpedal from his oft-quoted line, explaining: “I don’t think they’re evil per se. It’s just, they, I mean there’s nothing wrong with having a futures contract or something of the sort. But they do let people engage in massive mischief.”
The problems arise, Mr. Buffett said, when a bank’s exposure to derivatives balloons to grand proportions and uninformed investors start using them.
It “doesn’t make much difference if it’s, you know, one guy rolling dice against another, and they’re doing $5 a throw. But it makes a lot of difference when you get into big numbers.”
What worries him most is the big financial institutions that have millions of contracts. “If I look at JPMorgan , I see two trillion in receivables, two trillion in payables, a trillion and seven netted off on each side and $300 billion remaining, maybe $200 billion collateralized,” he said, walking through his thinking. “That’s all fine. But I don’t know what discontinuities are going to do to those numbers overnight if there’s a major nuclear, chemical or biological terrorist action that really is disruptive to the whole financial system.”
“Who the hell knows what happens to those numbers?” he asked. “I think it’s virtually unmanageable.”
Mr. Buffett defended Berkshire Hathaway’s use of derivatives, arguing that the company maintains a limited amount. At the time of the interview, the company had only about 250 derivative contracts. (It’s now down to 203.) “I want to know every contract, and I can do that with the way we’ve done it. But I can’t do it with 23,000 that a bunch of traders are putting on.”
He noted that when Berkshire bought General Re in 1998, the reinsurance company had 23,000 derivative contracts. “I could have hired 15 of the smartest people, you know, math majors, Ph.D.’s. I could have given them carte blanche to devise any reporting system that would enable me to get my mind around what exposure that I had, and it wouldn’t have worked,” he said to the government panel. “Can you imagine 23,000 contracts with 900 institutions all over the world with probably 200 of them names I can’t pronounce?” Berkshire decided to unwind the derivative deals, incurring some $400 million in losses.
Mr. Buffett said he used derivatives to capitalize on discrepancies in the market. (That’s what other investors must think they are doing — just not as successfully.)
Perhaps the most insightful nugget in the interview was Mr. Buffett’s explanation of why corporations use derivatives — and why they probably shouldn’t.
Many companies, as diverse as Coca-Cola and Burlington Northern, argue that they employ derivatives to hedge their risk.
The United States-based Coca-Cola tries to protect against fluctuations in currencies since it does business around the world. Burlington Northern, the railroad giant, uses the investments to limit the effect of fuel prices.
Mr. Buffett, who has interests in both companies, claimed there was another agenda. “The reason many of them do it is that they want to smooth earnings,” he said, referring to the idea of trying to make quarterly numbers less volatile. “And I’m not saying there’s anything wrong with that, but that is the motivation.”
The numbers all even out eventually, he cautioned, so derivatives don’t really make much difference in the long term.
“They’re going to lose as much on the diesel fuel contracts over time as they make,” he said of Burlington Northern. “I wouldn’t do it.”