Warren Buffett’s Fall From Grace
openthemagazine.com
openthemagazine.com
1) criticized derivatives and now holds "$63B" of them
2) is lobbying congress to "rid the bill of its ‘retrospective effect’ clause" that might effect his financials
3) backs GS/Blankfein and says they did nothing wrong
While at first blush they should raise questions I don't think the author makes any substantive claims against Buffett's reputation.
1) He criticized derivatives because the way their reporting effects earnings and because their profits are partially based on the other side's credit worthyness. I believe a large portion of the derivatives he owns are put options he has sold on equity indices. So he's not exposed to credit worthyness of counterparties because he's already been paid. I'm not sure but probably the derivatives he criticized as too complex and potentially destructive were things like CDOs/CLOs and other financial engineering products. I think Buffett understands put options very well, so that statement doesn't apply here.
2) He's not opposed to having derivatives accounted for differently, only differently in retrospect as well. I think its reasonable to say "I like the new set of rules, but please don't penalize me for acting in accordance with the rules in the past."
3) He does have investments in GS and this probably does effect his judgement, but the author doesn't really try to prove GS did anything wrong, so his backing of them can't really be said to be wrong (yet, though I don't think it will prove to be wrong).
I think he is taking some of Buffet's words out of context. It seems impossible that Buffet would say he doesn't understand derivatives. I understand them, and unlike him, I don't own companies that pretty much have to use them.
For instance he owns Burlington Northern, a railroad (which he's had a stake in for a long time). Companies whose profits are reliant on fuel costs (railroads, trucking, airlines, retailers with their own distribution system, etc.) almost always use derivatives to hedge against rising oil prices.
I'm guessing Buffet was speaking only about derivatives based on asset-backed securities in the consumer credit sector, which were relatively new and poorly understood and, as he pointed out, incredibly dangerous.
a) An explanation of the derivatives Buffett holds, and the reasons for holding them is provided in his 2008 shareholders letter:
http://www.berkshirehathaway.com/letters/2008ltr.pdf
It should also be noted that he exited a large number of derivatives contracts that he inherited with General Re prior to the GFC as he felt unable to manage or understand them.
b) Buffett is arguing against retrospective changes WRT derivatives accounting. There's nothing wrong with objecting when people are discussing a retrospective change to the rules that you were operating within.
c) As far as I can tell, the author would pillory anyone who doesn't attack Goldman Sachs. Buffett is entitled to his opinion.
I understand that the US Constitution is truly on the way out but it did have this bit : "No State shall ... pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts..."
I'm pretty sure that used to be taken to mean the federal government wouldn't do it either, but then that can't be reconciled with minimum wage laws either.
Maybe that's all uncertain but I'm confident the article is relatively thoughtless.
Sadly that is probably not true. Every person buying a synthetic CDO knew that on the other end of the wager was someone (usually a hedge fund manager) holding the opposite bet (a credit default swap). Every synthetic CDO was a zero sum wager, and the people buying it knew that.
(I'm pretty sure that all of the CDOs at issue in this case were synthetics, though it doesn't matter too much to the person buying them. There's effectively no difference between a synthetic and a non-synthetic.)
At the time Paulson wasn't any different than any other hedge fund manager, insofar as any synthetic CDO purchaser knew. The people taking they long end of the subprime market at that point were still under the impression that the ratings agencies were at least reasonably close to accurate.
Effectively what the wager came down to was Paulson saying "the rating agencies are wildly incorrect" and his counterparties saying "no they're not".
That GS brought in an outside agent, ACA, to me suggests that the portfolio construction was supposed to have some oversight to prevent the box of bad bananas scenario. If not, then why was there a third party agent? GS becomes culpable since they made the representation to the sellers of the insurance that there was an independent third party monitoring the construction, when in fact they knew it was really Paulson driving the portfolio construction.
If you bet that the Yankees would win, you can be sure that someone else believed the Yankees would lose. Similarly, if you received a synthetic sports bet, with a payoff of 100 x Yankee win + 100 x Red Sox win + 100 x Blue Jays win, you can be sure that someone else thinks that at least 2 of the 3 teams will lose. If you lose this bet, you've got no cause for complaint since you were trying to do the same thing to the other guy.
Paulson picked (in their opinion) the worst securities out there. ACA picked (in their opinion) the best of the worst. Everyone on the long side of this bet (which includes Goldman) believed Paulson was wrong and were fully prepared to take their money.
Hindsight is 20/20 though.
It's the worst-performing (in hindsight too) tranches of bonds backed by mortgages that get into a CDO. Nobody needed to repackage the higher tranches because they were assumed to be risk-free and given the same rating as US Treasuries so they were just sold as bonds.
Synthetic CDOs were all built to effectively wager against credit default swaps, which were all hand-selected by investors (mostly hedge fund managers). If you purchased synthetic CDOs then of course they were hand-selected rotten bananas, but you were wagering (incorrectly) that the rating models used by S&P and Moodys were correct in assuming that if you got enough rotten bananas together, you were left with 80% good bananas and 20% really rotten ones.
Berkshire was not hiding the fact they owned these derivatives. Buffett has talked about thm many times and defends purchasing this specific set of derivatives as having been "mispriced at inception" which I think is the most basic plan of all investing, right. Buy low, sell high.
As to the lobbying of congress, I would do the same thing, and you would too. When the derivitives contracts were drawn up Berkshire offered both a collatoralized and uncollatoralized option for the contract. The other parties would have paid a higher premium to Berkshire for the collatoralized contract, so they selected to forgo collatoral. Now, after the fact congress is going to step in and demand the contract have collatoral?
If I borrow money unsecured, I'm going to pay a higher interest rate. It would be extremely crappy to come in half way through the loan and demand that I put my house up ad collatoral. Now I have all the risk, and didn't even get to benefit from the lower I intrest rate at inception.
THAT'S what he's lobbying against.
And ontop of all of that, Buffett has said that if congress does include retroactive collatoralization, he will just pay it and his business will still be fine. So where's the fall from grace?