Berkshire Hathaway
On Learning Things the Hard Way III

Related Links
Discussion Boards

By rclosch
April 27, 2009

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

There has been a lot of talk in the media about how our current credit crisis has damaged our economic system, and the usually muttering from the left about the evil nature of our economic system. While these attitudes are normal and to be expected, it seems to me they are be based on a fundamental misconception about economics and human behavior. I admit that this will never be a popular view, but it seems to me that the reason capitalism works and that socialism does not is that capitalism is able to correct its mistakes. The problem is that this has not been, and never will be a painless process. Until there is pain there is no will to correct. Or as I have said before, when it comes to economic systems, pain is the mother of wisdom. The good news is that as opportunities for accumulating wisdom go, this one is going to be a beaut.

I wish it were not so. I wish that I could believe that the introduction some ideal, beneficent political system could magically eliminate the pain from the human condition, but the older I get the more I find that my mind rebels from any suggestion of a painless, mistake free existence. The biggest problem with our corrective process is that instead of searching for causes and corrections we spent most of our time looking for something or someone to blame.

Economic crashes are nothing new. In the United States there were six in the Nineteenth Century and three in the Twentieth Century, while the causes of these crashes were not always the same, in each case the damage tended to be short term while the long term result has been a stronger economy. The great depression generated a productive machine that could produce jeeps, tanks, airplanes and bullets cheaper and faster than any other country, and so helped the country to win World War II, and dominate the Worlds economy for the next 20 years.

The great inflation of the seventies eventually gave us two decades of prosperity and unprecedented international growth. What our current turmoil will produce we cannot imagine now anymore than we could have predicted the future in 1940 or 1980, but we should keep in mind that the crashes in the past led eventually to a stronger economic system, and not to collapse.

Credit Default Swaps

Regulation of credit default swaps should be easy; after all they are just a form of insurance. Insurance companies have been highly and more or less successfully regulated for more than a century. While we certainly do not want state by state regulation of credit default swaps some form of federal rules similar to those that require sellers to be licensed, disclose the amount of business that they write; and require the companies that are assuming risk be required to maintain capital reserves sufficient to cover the losses that result from the contracts they write. These rules are not just of interest to the public but are an important protection for investors in the stock companies doing this business.

With something like $50 or $60 trillion of CDS estimated to have been in existence last year. The need for regulation would seem obvious. Presently there are plans to set up an exchange to clear these transactions and this would help to create transparency and could set rules for posting of collateral. While this might reduce some of the confusion (estimates of the notational amount of CDS outstanding have been more than cut in half since the first of the year by just eliminating duplicate and offsetting contracts) it is not clear that this would be enough to prevent the kind of abuse that was AIG.

Logic would suggest that with the proper regulation this would be an interesting business for Berkshire Hathaway, with their large Insurance business and expertise in assessing financial risks, it would in a sense be just an extension of their existing business. But for this business to be attractive to Buffett there would have to be strong capital requirements for anyone wanting to write this insurance. Otherwise we have the situation we just escaped were anyone that could sign his name to a contract was able to collect a premium. It made not matter whether or not they had any idea as to the size of the risks they were insuring or whether or not there was any chance that they could pay for the losses that they were supposed to be covering.

Buffett has written CDS business in the past and has indicated that he might in the future, but he has said he will not sign any contact that requires him to post collateral. The reason is no mystery; the reason that the insurance business has been so good for Berkshire is the float (the premium money that they get to hold until they have to pay claims). If there is an exchange holding collateral they would be holding the float not Berkshire. So we can assume that Buffett would prefer regulation similar to the insurance business, as opposed to regulation built around a clearing house or exchange. For this kind of business to be attractive to Berkshire the capital requirements would have to be high enough to limit the number of parties that could write this business, otherwise it competition would drive premiums too low to provide a profit. In fact it would seem that as far as Berkshire is concerned the higher the capital requirements the better.

From the investors standpoint there must be protection from situation at AIG. By the time that the shareholders discovered the extent of risks AIG was taking with their credit default swaps business the shareholders were already broke and the company was in hock to the government for $180 billion. Obviously AIG did not have enough capital to cover the risks they were accepting with these contracts and the premiums they were charging were imbecilic. It is difficult to understand how this situation got so far out of control. But the solution would appear to be simple enough. No company should be allowed to write this insurance unless they have the capital to cover the risks that they assuming, and shareholders should have an absolute right to enough information to understand the risks their company is exposed to. Under these circumstances it is likely that this would be a very profitable business for Berkshire.