Chairman's letter 2002
In this
line of business (re-insurance), we assume from
another insurer the obligation to pay up to a specified amount for losses they
have already incurred – often
for events that took place decades earlier – but that are yet to be paid (for
example, because a worker hurt in
1980 will receive monthly payments for life). In these arrangements, an insurer
pays us a large upfront premium,
but one that is less than the losses we expect to pay. We willingly accept this
differential because a) our
payments are capped, and b) we get to use the money until loss payments are
actually made, with these often
stretching out over a decade or more.
When we write a
retroactive policy, we immediately record both the premium and a reserve for
the expected losses.
The difference between the two is entered as an asset entitled “deferred
charges – reinsurance
assumed.” We then amortize
this asset downward by charges to income over the expected life of each policy.
These charges create an underwriting loss, but one
that is intentional and desirable.
Derivative- Essentially,
these instruments call for money to change hands at some future date, with the
amount to be determined by
one or more reference items, such as interest rates, stock prices or currency
values. If, for example, you are
either long or short an S&P 500 futures contract, you are a party to a very
simple derivatives transaction –
with your gain or loss derived from movements in the index. Derivatives
contracts are of varying duration
(running sometimes to 20 or more years) and their value is often tied to
several variables.
Unless
derivatives contracts are collateralized or guaranteed, their ultimate value
also depends on the creditworthiness
of the counterparties to them. In the meantime, though, before a contract is
settled, the counterparties
record profits and losses – often huge in amount – in their current earnings
statements without
so much as a
penny changing hands.
The range of derivatives
contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).
At Enron, for example, newsprint and broadband derivatives, due to be settled
many years in the future,
were put on the books. Or say you want to write a contract speculating on the
number of twins to be born in Nebraska in 2020. No
problem – at a price, you will easily find an obliging counterparty. 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. In the twins scenario, for example, 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.
Another problem
about derivatives is that they can exacerbate trouble that a corporation has
run into for completely
unrelated reasons. This pile-on effect occurs because many derivatives
contracts require that a
company
suffering a credit downgrade immediately supply collateral to counterparties.
Imagine, then, that a
company is
downgraded because of general adversity and that its derivatives instantly kick
in with their
requirement,
imposing an unexpected and enormous demand for cash collateral on the company.
The need to meet this demand
can then throw the company into a liquidity crisis that may, in some cases,
trigger still more downgrades. It
all becomes a spiral that can lead to a coIn banking, the recognition of a
“linkage” problem was one of the reasons for the formation of the Federal Reserve
System. Before the Fed was established, the failure of weak banks would
sometimes put sudden and
unanticipated liquidity demands on previously-strong banks, causing them to
fail in turn. The Fed now
insulates the strong from the troubles of the weak. But there is no central
bank assigned to the job of preventing the
dominoes toppling in insurance or derivatives. In these industries, firms that
are fundamentally
solid can become troubled simply because of the travails of other firms further
down the chain.
When a “chain
reaction” threat exists within an industry, it pays to minimize links of any
kind. That’s how we conduct our reinsurance business, and
it’s one reason we are exiting derivatives.rporate meltdown. Many people
argue that derivatives reduce systemic problems, in that participants who can’t
bear certain risks
are able to transfer them to stronger hands. These people believe that
derivatives act to stabilize the economy,
facilitate trade, and eliminate bumps for individual participants. And, on a
micro level, what they say is
often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives
transactions in order to
facilitate certain investment strategies.
Charlie and I
believe, however, that the macro picture is dangerous and getting more so.
Large amounts of risk,
particularly credit risk, have become concentrated in the hands of relatively few
derivatives dealers, who in
addition trade extensively with one other. The troubles of one could quickly
infect the others. On top of that,
these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties,
as I’ve mentioned, are linked in ways that could cause them to
contemporaneously run into a problem because
of a single event (such as the implosion of the telecom industry or the
precipitous decline in the value of
merchant power projects). Linkage, when it suddenly surfaces, can trigger
serious systemic problems.
One of the
derivatives instruments that LTCM used was total-return swaps, contracts that
facilitate 100% leverage in
various markets, including stocks. For example, Party A to a contract, usually
a bank, puts up all of the
money for the purchase of a stock while Party B, without putting up any
capital, agrees that at a future date it
will receive any gain or pay any loss that the bank realizes.
Total-return
swaps of this type make a joke of margin requirements. Beyond that, other types
of derivatives
severely curtail the ability of regulators to curb leverage and generally get
their arms around the risk profiles of
banks, insurers and other financial institutions. Similarly, even experienced
investors and analysts
encounter major problems in analyzing the financial condition of firms that are
heavily involved with
derivatives
contracts. When Charlie and I finish reading the long footnotes detailing the
derivatives activities
of major banks,
the only thing we understand is that we don’t understand how much risk
the institution is
running.
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.
In stocks, we expect every
commitment to work out well because we concentrate on conservatively financed
businesses with strong
competitive strengths, run by able and honest people. If we buy into these
companies at sensible prices, losses
should be rare.
Purchasing junk
bonds, we are dealing with enterprises that are far more marginal. These
businesses are usually
overloaded with debt and often operate in industries characterized by low
returns on capital. Additionally,
the quality of management is sometimes questionable. Management may even have
interests that are
directly counter to those of debtholders.
The current cry
is for “independent” directors. It is certainly true that it is desirable to
have directors who think and
speak independently – but they must also be business-savvy, interested and
shareholder-oriented.
Chairman's letter 2003
Nil
Chairman's letter 2004
There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.
stay with simple propositions – that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%.
Chairman's letter 2005
To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks. After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.
But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.
After a while, most of the family members realize that they are not doing so well at this new “beatmy-brother” game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers. The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s finances have taken a turn for the worse. The solution? More help, of course.
It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.
The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. “What,” the new Helpers ask, “can you expect from such a bunch of zombies?”
The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with selfconfidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives. The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.
And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).
Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole,
returns decrease as motion increases.
