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Lessons from Warren Buffett - XLVI

Jul 16, 2008

Last week, in our concluding article on Buffett's letter for the year 2000, we discussed master's views on tendencies of certain CEOs to make lofty projections of their companies' future earnings potential and the risks associated with such projections. Let us now move on to accumulating wisdom from the letter for the year 2002*.

In his 2002 letter, Warren Buffett has devoted a fair deal of time and space to the topic of derivatives. Infact, the master's prognosis on the risks associated with derivatives come so perilously close to describing the current US sub-prime crisis that one would be forgiven for assuming that Mr. Buffett has access to a crystal ball.

Derivatives: Devious or delightful?
Much like most of the other inventions, derivatives too, were created for the benefit of mankind in general and commerce and trade in particular. It was especially helpful to smaller firms that did not have the capacity to bear big risks. Derivatives enabled such firms to transfer some of these risks to stronger, more mature hands. But again, like most of the other inventions, derivatives can also be put to misuse. Abuse of the same, as has become more frequent these days, could lead to dire consequences. Furthermore, the very nature of a derivatives contract makes it risky to the users. This is because unless accompanied by collaterals or guarantees, the final value in a contract depends on the payment ability of the parties involved.

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The master is also of the opinion that since a lot of derivatives contract don't expire for years and since they have to be provided for in a company's accounts, manipulation could become a serious threat. For e.g., incorporating overly optimistic projections into a contract that does not expire until say 2018 could lead to inflated earnings currently. However, if the projections fail to materialize, they could lead to potential losses in the future. In an era of short-term profit targets and incentives, such measures result in higher CEO salaries. But they hurt long-term shareholder value creation.

This is what the master has to say on the issue:
"Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one's commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on "earnings" calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and "mark-to-model" is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions."

He further goes on to add "The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth."

Highlighting other dangers of derivatives, the master finally goes on to say something that if central banks around the world, importantly the US Fed, would have paid proper heed to, it could have been probably able to avert or maybe minimize the enormous damage that is being caused by the US sub-prime crisis.

We conclude the article with the reproduction of that comment.

Weapons of mass destruction
The master says, "The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts."

*Since letter for the year 2001 is a little light on investment wisdom, we have decided to omit the same.

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