Dollars and Jens
Saturday, February 28, 2009
From Warren Buffett's new letter to shareholders (PDF):
Derivatives contracts, in contrast, often go unsettled for years, or even decades, with counterparties building up huge claims against each other. "Paper" assets and liabilities – often hard to quantify – become important parts of financial statements though these items will not be validated for many years. Additionally, a frightening web of mutual dependence develops among huge financial institutions. Receivables and payables by the billions become concentrated in the hands of a few large dealers who are apt to be highly-leveraged in other ways as well. Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It's not just whom you sleep with, but also whom they are sleeping with.A related problem is that government rescue operations give preference to those who take on systemic risks. If you took a risk that would cost you a lot of money in scenarios in which nobody else gets hurt, you'd have to eat that loss. But if everybody else is lending money to people who can't pay it back and you jump on the bandwagon, your problem carries a lot more political weight when the subprime mortgages hit the fan.
Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it assures them government aid if trouble hits. In other words, only companies having problems that can infect the entire neighborhood – I won't mention names – are certain to become a concern of the state (an outcome, I'm sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won't do; it's mindboggling screw-ups that are required.
We'd be better off if our stupidities were uncorrelated, but correlated stupidity comes with better political insurance.