Monday, May 03, 2010

Buffett talks up his book(s), drinks the koolaid

Topics today:
I. Financial Weapons of Mass Destruction?

II. “All-in wager” on the American economy?

I. Buffet's change of heart on FWMD:

Buffett warns on investment 'time bomb' (2003)
The derivatives market has exploded in recent years, with investment banks selling billions of dollars worth of these investments to clients as a way to off-load or manage market risk.

But Mr Buffett argues that such highly complex financial instruments are time bombs and "financial weapons of mass destruction" that could harm not only their buyers and sellers, but the whole economic system.

Derivatives are financial instruments that allow investors to speculate on the future price of, for example, commodities or shares - without buying the underlying investment.

Some derivatives contracts, Mr Buffett says, appear to have been devised by "madmen".

He warns that derivatives can push companies onto a "spiral that can lead to a corporate meltdown", like the demise of the notorious hedge fund Long-Term Capital Management in 1998.

Berkshire Hathaway, the investment group led by Mr Buffett, is pulling out of the market, closing down the derivatives trading subsidiary it bought as part of a huge reinsurance company a few years ago.

In his letter Mr Buffett compares the derivatives business to "hell... easy to enter and almost impossible to exit", and predicts that it will take years to unwind the complex deals struck by its subsidiary General Re Securities.
Warren Buffet on Derivatives -- excerpts from the Berkshire Hathaway annual report for 2002.
I view derivatives as time bombs, both for the parties that deal in them and the economic system.

before a contract is settled, the counter-parties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose accuracy may not be exposed for many years.

The errors usually reflect 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 art, on “earnings” calculated by mark-to-market accounting. But often there is no real market, 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 counter-parties to use fanciful assumptions. 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.

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counter-parties tend to build up over time.

A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. However under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from companies B through Z.

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.

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.

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. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Buffett boosts Goldman Sachs with $5-billion investment (2008)
Warren Buffett to the rescue: His Berkshire Hathaway Inc. agreed today to invest $5 billion in Goldman Sachs Group via a purchase of preferred stock.

Berkshire also will get warrants to buy up to $5 billion of Goldman common shares.

The deal, announced after markets closed, amounts to a huge vote of confidence by Buffett in the investment banking titan, at a time when investors remain spooked about the future of Wall Street.

"Goldman Sachs is an exceptional institution," Buffett said in a statement.

Buffett will earn a hefty 10% dividend yield on his preferred shares. The warrants, which are immediately exercisable, have a strike price of $115 a share.

The deal has given Goldman’s shares a pop in after-hours trading, to $135.87. The stock had gained $4.27 to $125.05 in regular trading, after falling as low as $113.
Goldman was down 15 points at $145 at last Friday's close (April 30).

The Buffett-Blankfein Alliance (current)
Goldman Sachs shares should pop Monday morning on the unambiguous support of America’s most renowned investor, Warren Buffett.

According to a Belgian fund manager who worked for seven years for Goldman in London, and who just arrived here in Pasadena for the Value Investing Congress this week, Goldman Sachs ( GS - news - people ) has an intrinsic book value of $111 a share and that book value should rise at least to $132 a share over the next six months unless disaster strikes.
Goldman Sachs has mounting legal woes
Shares of Goldman (GS, Fortune 500) have plunged 21% since the SEC first revealed its fraud allegations, including a 9% drop on Friday as news of the federal criminal probe prompted a pair of analysts to cut their rating on the firm.

The interesting thing to Guambat is how sanguine Buffett is about all that CDO Koolaid -- he's now apparently quite prepared to drink the stuff Goldman stirred up and peddled.

As Barry Ritholtz has pointed out, the WSJ has a take on just how toxic the CDO Koolaid can be, and how Goldman followed the recipe:

Senate's Goldman Probe Shows Toxic Magnification
In a memo last week, panel Chairman Sen. Carl Levin (D., Mich.) said Goldman's work "magnified the impact of toxic mortgages" by replicating mortgage securities in debt pools known as collateralized debt obligations as well as CDO derivatives, and also in an index that tracks subprime bonds.

This was a central finding of the Senate investigative panel probing Goldman Sachs Group Inc.'s actions in the mortgage market. In effect, the documents said, Wall Street was "copying and pasting" what turned out to be the worst-performing securities of the mortgage boom.

An important moment in the housing cycle came in January 2006, a year before the downturn of the housing market had crystallized. That month, a consortium of banks, including Goldman and Deutsche Bank AG, with the help of a London data firm, launched an index, known as the ABX, which served as a proxy for subprime loans.

By late 2006, Goldman had a large bullish position on the ABX, because it had taken the other side of bearish bets by hedge-fund clients, according to the Senate documents. Subsequent deals would help reverse that position.

Anthony Sanders, a real-estate finance professor and authority in securitization at George Mason University in Fairfax, Va., said the problem was that the same mortgage bonds ended up in many deals, potentially multiplying the losses.

"Serious problems with common [asset-backed securities] deals can decimate all CDO deals," Mr. Sanders said.
That last statement sounds very much like pre-Goldman Buffett:
"Under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from companies B through Z. 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."
But, by 2008, Buffett had finally learned enough about the direction of the economy that he was willing to make his own bet against it, by taking a position in Goldman, whose own derivative-based bet was about to pay off -- with a little bail out assistance at the net by Buffett's shareholders and other US taxpayers.


Topic II: Jumping the tracks

Buffett on right track? (2009)
The headline story was that Buffett was purchasing a US railroad. Not just any old purchase, this one was his largest purchase ever. The traders skipped right over the part where Buffett said the purchase was an “all-in wager on the economic future of the United States”, and landed on the notion that transports ultimately lead the industrials in the stock market race.

Feisty Buffett supports Goldman, high on economy (current)
Buffett cautioned policymakers not to artificially stimulate housing sales and perhaps derail a recovery.

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