Sage of Omaha Says Transparency Alone Will Not Cure Derivatives Danger; Endorses Mark-to-Market Accounting

In his annual letter to shareholders, Warren Buffet reiterated the danger of derivatives and also said that improved transparency, a favorite remedy of policymakers and financial regulators for averting future train wrecks, won’t cure the problems that derivatives pose. Mr. Buffet said he knows of no reporting mechanism that would come close to measuring the risks in a huge and complex portfolio of derivatives, adding that auditors can’t audit these contracts, and regulators can’t regulate them. When he read the pages of disclosure in 10-Ks of companies that are entangled with these instruments, all he ended up knowing was that he did not know what was going on in their portfolios.

He went on to say that derivatives dramatically increased the leverage and risks in the financial system. They have made it almost impossible for investors to understand and analyze large commercial banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years. So indecipherable were Freddie and Fannie that their federal regulator, OFHEO, whose more than 100 employees had no job except the oversight of these two institutions, totally missed their cooking of the books.

Further, there is the counterparty exposure. According to Mr. Buffet, the Bear Stearns collapse highlights the counterparty problem embedded in derivatives transactions. He likened this to a time bomb. On April 3, 2008, Tim Geithner, then president of the New York Fed, explained the need for a rescue by stating that the sudden discovery by Bear’s derivative counterparties that important financial positions they had put in place to protect themselves from financial risk were no longer operative would have triggered substantial further dislocation in markets. Mr. Buffet described the remarks as Fedspeak, for “We stepped in to avoid a financial chain reaction of unpredictable magnitude.”

A normal stock or bond trade is completed in a few days. Counterparty risk therefore quickly disappears, said Mr. Buffet, which means credit problems can’t accumulate. This rapid settlement process is key to maintaining the integrity of markets. That is the reason the NYSE and NASDAQ shortened the settlement period from five days to three days in 1995. Derivatives contracts, in contrast, often go unsettled for years, or even decades, with counterparties building up huge claims against each other. Unquantifiable paper assets and liabilities become important parts of financial statements even 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.

While endorsing mark-to-market accounting, Mr. Buffet also said that the models used to value illiquid asset-backed securities were flawed. In his view, the stupefying losses in mortgage-backed securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford.

He cautioned investors to be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols.

Specifically, he believes that the Black-Scholes formula, even though it is the standard for establishing the dollar liability for options, produces strange results when the long-term varieties are being valued. Derivatives subjected to mark-to-market accounting will produce wild swings in reported earnings. That result neither cheers nor bothers Mr. Buffet, who added that the downs can be helpful in that they give him an opportunity to expand a position on favorable terms.

The Black-Scholes formula has approached the status of holy writ in finance, conceded Mr. Buffet, and his company uses it when valuing their equity put options for financial statement purposes. If the formula is applied to extended time periods, however, it can produce absurd results. In fairness, he pointed out that Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first unveiled the formula.