Berkshire Hathaway 2009 Annual Meeting Audience Question # 16

Ben Graham would not have liked derivatives

Warren Buffett:

OK, number 8.

Audience Member:

Hi, Mr. Buffett. Hi, Mr. Munger. My name is Mary Kimble from New York City.

In getting back to basics, what do you think Ben Graham would have said about derivatives?

Warren Buffett:

He would not have liked them. I think he probably would’ve said pretty much what I said back in 2002, that they pose a real risk to the system.

They cause leverage to run wild. They cause counterparties to sign up for things that may be difficult to achieve under certain circumstances. That they place an already fragile economic system… added strains on them… which can pop up in unpredictable ways.

But he would probably also say if he saw some that were mispriced, he would act accordingly. But he wouldn’t get himself in a position where the problems of the people who didn’t act prudently could cause him any problems. And I think that probably would be the answer.

The… one of the… one basic problem on derivatives… well, there are several problems.

I mean, back in… after 1929, Congress met… there was a Pecora committee and so on… and they decided that it was very dangerous to let people borrow a lot of money against securities and that it contributed to the Great Depression.

And therefore, they said the Federal Reserve should regulate how much people could borrow against securities. And it was important for society.

And the Federal Reserve started requiring margin… they had margin requirements. Those requirements still exist. You are not supposed to be able to borrow more than 50 percent against your securities.

Actually, during one period, they went to where they didn’t… the Federal Reserve allowed no borrowing whatsoever. They went to a hundred percent margin.

But derivatives came along and just turned that into a… made those rules a laughingstock. You have what they call “total return swaps,” which means you can borrow a hundred percent against what you own. That goes way beyond anything that existed in 1929.

So derivatives became a way around regulation of leverage in markets, which like I say, Congress felt was important and the Federal Reserve still has a responsibility for enforcing.

Derivatives also meant that settlement dates got pushed out. One of the problems in securities markets comes about when you have a trade today, if you had… didn’t have to settle it for a year, you’d find it very hard sometimes to find the person on the other side.

And derivatives allow these very long settlement periods. Whereas security markets demand them in three days. There’s a reason they demand them in three days.

As you extend out periods, you get more and more defaults. So they’re a danger… they are a danger to the system. There’s no question about that.

We have a book in The Bookworm called “The Great Crash” by Galbraith. It’s one of the great books. You really ought to buy it. It tells the story of the ’29 and it gets into margin requirements, so…

Ben Graham would not like a system that used derivatives heavily. But he would… I don’t think he would have been above… if he saw something that looked way out of line and he knew he could handle it himself… I think he would have been quite willing to buy or sell one that was mispriced.


Charlie Munger:

I think there’s been a deeper problem in the derivative business. The derivative dealer takes two advantages of the customer.

One, there’s croupier-style mathematical advantage equivalent to the house advantage in Las Vegas.

And two, the derivative dealer is playing in the same game with his own clients, with the advantage of being a better player. So…

Warren Buffett:

And having knowledge of what they’re doing.

Charlie Munger:

… and having knowledge of what the clients are doing.

This is basically a dirty business. And you’re really selling things to your clients who trust you, that are bad for the clients.

We don’t need more of this kind of thing in America. We need less.

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