Warnings About Financial Institutions and Derivatives

Risks of Financial Institutions
The nature of a financial institution is that there are a lot of ways to go to hell in a bucket. You can push credit too far, do a dumb acquisition, leverage yourself excessively---its not just derivatives [that can bring about your downfall].

Maybe it's unique to us, but we're quite sensitive to financial risks. Financial institutions make us nervous when they're trying to do well.

We're exceptionally goosey of leveraged financial institutions. If they start talking about how good their risk management is, it makes us nervous.

We fret way earlier than other people. We've left a lot of money on the table through early fretting. It's the way we are -- you'll just have to live with it.

Derivatives
The system is almost insanely irresponsible. and what people think are fixes aren't realy fixes. It's so complicated I can't do it justice here - but you can't believe the trillions of dollars involved. You can't believe the complexity. You can't believe how difficult it is to do the accounting. You can't believe how big the incentives are to have wishful thinking about values and wishful thinking about ability to clear.

People don't think about the consequences of the consequences. People start by trying to hedge against interest rate changes, which is very difficult and complicated. Then, the hedges make the [reported profits] lumpy. So they use the new derivatives to smooth this. Well, now you've morphed into lying. This turns into a Mad Hatter's Tea Party. This happens to vast, sophisticated corporations.

Somebody has to step in and say, "We're not going to do it - it's just too hard."

I think a good litmus test of the mental and moral quality at any large institutions [with significant derivative exposure] would be to ask them, "Do you really understand your derivatives book?" Anyone who says yes is either crazy or lying.

It's easy to see [the dangers] when you talk about [what happened with] the energy derivatives - they went kerflooey. When [the companies] reached for the assets that were on their books, the money wasn't there. When it comes to financial assets, we haven't had any such denouement and the accountings hasn't changed so the denouement is ahead of us.

Derivatives are full of clauses that say if one party's credit gets downgraded then it has to put up collateral. It's like margin - you can go broke [just putting up more margin]. In an attempt to protect themselves, they've introduced instability. Nobody seems to recognize what a disaster of a system they've created. It's a demented system. 

In engineering people have a big margin of safety. But in the financial world, people don't give a damn about safety. They let it balloon and balloon and balloon. It's aided by false accounting. I'm more pessimistic about this than Warren is.

Accounting for Derivatives
I hate with a passion GAAP [Generally Accepted Accounting Principles] as applied to derivatives and swaps. JP Morgan sold out to this type of accounting to front-end revenues. I think it's a disgrace.

It's bonkers, and the accountants sold out. Everyone caved, adopted loose [accounting] standards, and created exotic derivatives linked to theoretical models. As a result, all kinds of earnings, blessed by accountants, are not really being earned. When you reach for the money, it melts away. It was never there.

It [accounting for derivatives] is just disgusting. It is a sewer, and if I'm right, there will be hell to pay in due course. All of you will have to prepare to deal with a blowup of derivative books.

Likelihood of a Derivatives Blowup
We tried to sell Gen Re's derivatives operations and couldn't, so we started liquidating it. We had to take big markdowns. I would confidently predict that most of the derivatives books of [this country's] major banks cannot be liquidated for anything like what they're carried on the books at. When the denouement will happen and how severe it will be, I don't know. But I fear the consequences could be fearsome. I think there are major problems, worse than in the energy field, and look at the destruction there.

I'll be amazed if we don't have some kind of significant [derivatives-related] blowup in the next five to ten years.

I think we're he only big corporation in America to be running off its derivative book.

It's a crazy idea for people who are already rich -  like Berkshire - to be in this business. It's a crazy business for big banks to be in.

Yo would be disgusted if you had a fair mind and spent a month really delving into a big derivative operation. You would think it was Lewis Carroll. You would think it was the Mad Hatter's Tea Party. And the false precision of these people is just unbelievable. They make the worst economics professors look like gods. Moreover, there is depravity augmenting the folly. Read the book F.I.A.S.C.O., by law professor and former derivative trader Frank Partnoy, an insider account of the depravity of derivative trading at one of the biggest and best-regarded Wall Street firms. This book will turn your stomach.

There was a great article in the Economist about a conference for the Ameican Securitization Forum - the wonfderful people that brought us all these complex debt products that are giving banks no end of bellyache. Ironically the conference was held in Las Vegas, and a wonderful quote came from hedge fund manager John Devaney, who said "I'd like to thank the market for dealing me a direct hit. As a trader if you don't get sucker-punched every once in a while, you don't understand what risk is."

Also, there were a few good articles last week about how money managers had retreated from the market because they'd lost faith in the ability to model risk effectively.

If only it were so easy for information risk professionals, who often protect far more than just money - we protect innovation, national security, and even human life in some cases. It's not quite so easy for us to take a direct hit.

Financial markets have taken centuries to evolve, yet look at what can happen with their well established risk models. Information risk modeling is still only nascent, and changing at blistering pace. Yes, we need a more structured approach to information risk management - defining and comparing the different risks we face - but technology and business are evolving so fast that we need to temper our expectations about how scientific this can ever become.

The best quote I heard on this topic was from Hugh Voight of Solutionary, who says that "To get from New York to San Francisco, you don't need Google Maps until you get close to the Bay Area. At first, you just need to go West."

We still just need to "Go West" when it comes to modeling information risk. Bring on the Village People!