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Collection: Warren Buffett - #235 'How Derivatives Become Potential Dynamite'



Bill Graham (PH) from Los Angeles.

Warren, you’ve made it possible for outside shareholders to understand Berkshire’s financial businesses.

But there is one that seems, to me, anyway, hard to understand, which is the financial products business, which I guess, involves trading of derivatives.

And for the same — given the same kind of concerns that you and Charlie voiced in relation to financial businesses, can you help us out on that and why you’re comfortable with it?


Well, I think you put your finger on it, Bill.

It is a hard business to understand. And it’s a hard business to understand if you own it, let alone read about it in somebody else’s annual report.

And I would guess that most people who own complicated or extensive derivatives businesses, I would say that most of the CEOs probably don’t understand it. And how many of them stay awake at nights over that, I don’t know.

Actually, in financial products, what you see on that one line of income on that, and also what you see in the balance sheet items, is a combination of several things. It’s General Re Securities, which used to be GRFP, General Re Financial Products. It’s — and it’s a couple of other operations.

It actually had our — it has our — structured settlement business in it, which is quite predictable and a very easy business to understand.

And it actually has some trading business that I do that falls in there. It’s not our normal investment business, but it may involve, what I think are — it tends to be fixed-income related.

It might involve arbitrage or semi-arbitrage of various types of fixed-income securities. It wouldn’t involve any equity arbitrage. That would not be in there.

But I would say that it would be a fair criticism to say that neither Charlie nor I know fully, or even in large part, what goes on in the derivatives business.

Now, we have a fellow who is both smart and trustworthy running that in Mark Byrne. So we feel very good about the individual.

We do not feel the instinctive understanding of everything that’s going on that we do, probably, in most of the businesses that we’re in. I think we’ve probably got 17,000 outstanding tickets at General Re Securities. And those interplay in all kinds of ways.

And I don’t think that Charlie or I have my mind — our minds — around that book of products. That means we want to be very comfortable with the fellow whose job it is to have his mind around those products. And I will tell you that, you know, there’s nobody that I’d feel more comfortable with than Mark Byrne.

But it is — it’s not a natural-type business for us.

The other things in that area, we made a fair amount of money in some things that aren’t related to the derivative business last year. And those are under my direct control. So I feel okay about that.

The structured settlement business is a minor profit area. But it’s made us some money. And right now, it’s not attractive. But it could be again in the future.

And there could be other financial-type things we would stick in there. But if we stuck in anything, it would be something that I would be running.



Yeah, that mix includes what I would call oddball pastimes of Warren Buffett — (laughter) — outside —


The ones that are publishable. (Laughter)


— outside the common stock field. That I’m quite comfortable with, although I’m sure the results will be irregular.

The rest of it — and I think we also have what might be called oddball personal ideas of Mark Byrne, and I’m quite comfortable with those.

As you get away from that, into what might be called more standardized derivative trading businesses, I think it’s fair to say I like them less than most of the people do who are in them.


Quite a bit less. (Laughter)




Yeah, we regard that area as potentially being dynamite because if you get a group — a large group — of people that, in many cases in that business — although we’ve tried to go away from it ourselves — but in many cases in that business are getting paid based on front-ending potential profits, you can get — I mean, that’s a dangerous situation to place a hundred people in. You’re going to find people who will crack under that, in terms of what they will do.

You know, they had — we had a case of it, actually, in the electric utility industry a year or two ago, when Edison in California, through a subsidiary, compensated people based on projecting the profitability of the business they were putting on the books that day.

That’s Wall Street practice and it was brought to the utility industry. And it produced I’d say predictable results.

So it’s dangerous to pay people to make deals where you won’t know the outcome for 15 or 20 years and give them a lot of money upfront for doing it.

And that’s fairly standard practice in the business. I mean, it was standard practice at Salomon when I was there. And as I say, people occasionally crack under that.

It isn’t exactly analogous, but it’s worth reading Roger Lowenstein’s book entitled “When Genius Failed,” because it touches on some of the problems we’ve described that Charlie and I are apprehensive about.


Yeah, the derivatives business has the very significant problem that the accounting profession sold out. The accounting is improper. It front-ends way too much income.

It’s irrationally optimistic because that’s the way the denizens of the field want it because it creates bigger compensation. This is intrinsically an irresponsible system. And it’s another case where the accounting profession has failed the wider civilization.


We found — Charlie was on the audit committee at Salomon — and we found positions — single positions — mismarked by close to $20 million, for example, didn’t we, Charlie?


Oh, yeah. But deliberate mismarkings was not the main problem. The main problem is the whole system of accounting is wrong. The whole system of accounting is too optimistic. It would be like going into the taxi cab business with a 30-year depreciation rate.


Or it’d be like writing long, very long-tail insurance, and paying a big commission upfront based on the expected profit of that insurance over a 10-year period or something, with that prepared by the guy who wrote the policy.

There are certain activities that are really just dangerous in the financial world. And when you get close to that kind of situation, you just have to be very careful.

Now you — actually, Mark has been implementing a system that compensates — that accounts for this — significantly differently than occurs at many institutions. So, you know, you can try to attack it. But it’s also hard to get too far away from industry norms and still do business. I mean —


Yeah. Our accounting is way more conservative than the standard derivative accounting of the country, thank God.


OK. Area 6.


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