Warren Buffett famously called derivatives "financial weapons of mass destruction." Now he's a major shareholder in a bank that is one of the top dealers in those derivatives.
But Buffett and Charlie Munger have made comments about banks and the financial system that are at times hard to square with their holdings.
Here's Munger in 2011:
We would be better off if we downsized the whole financial sector by about 80%. I don't think the rest of us have anything to gain having massive trading between computers which try to outwit one another with their algorithms to the extent that when one succeeds, the rest of us are all paying for it. And why should we want to encourage our brightest minds to do what amounts to code-breaking and electronic trading? I think the whole system is stark-raving mad. Why should we want 25% of our graduating engineers going into finance? ... I don't see any social contribution.
How does that fit in with Berkshire's investments in big banks? He explained:
We buy the investments in the public market that are available. We don't tell the people running them what to do, and we don't allow our thoughts about what the law should be to change our investments. We invest in the world as it is. But if you ask me what the world should be, I would say that the finance sector of the world should be downsized by at least 80%.
Hmm. So, if shareholders aren't to keep an eye out after management, who should? Here's Munger in 2010:
Take soccer as an example. It's a tremendously competitive sport, and often times one team tries to work mayhem on the other team's best player. The referee's job is to limit this mayhem and rein in extreme forms of competition.
Regulation is similar. Most ambitious young men will be more aggressive than they should. That's what happened with investment banking. I mean, look at Lehman Brothers. Everyone did what they damn well wanted until the whole place was pathological about its extremeness.
When Hitler was in his bunker before he shot himself, he said, "This isn't my fault. The German people just don't appreciate me enough." That's the attitude of a lot of bankers. They think their silliness is necessary. Banks will not rein themselves in voluntarily. You need adult supervision.
The smart way to regulate is to act like a referee. You have to curtail the activities that are permitted. There should be less trying to fix things and more trying to prevent bad outcomes. There's an old saying, "an ounce of prevention is worth a pound of cure." That's wrong. An ounce of prevention can be worth an entire ton of cure.
Goldman, of course, isn't exempt from this culture. But Munger appears to have sympathy. Again, from 2010:
Goldman has the best morality of any of the big banks. From this sense, it's a little crazy to be attacking our best bank. I don't think the government did this [sue Goldman for fraud] to be asinine, but I don't think how they've handled it has been the appropriate response.
Goldman was in a world where Congress legalized all types of derivatives. It's an inherently dangerous world. Given that world, I see no reason to think Goldman misbehaved in some horrible fashion. Everyone was doing it, and it's only natural to increase your moneymaking activities when you can do so legally.
I think Jamie Dimon is a fine and admirable man. But the world would be better off if JPMorgan didn't run a gambling casino alongside a legitimate business. I take my hat off to Dimon, but I'd take away his derivative book in a second.
Speaking of derivatives, Munger is downright livid (from 2012):
Some of the most eminent and most admired people in finance, including Greenspan, argued that derivatives trading, in the [modern] form of the old bucket shop, was a great contribution to modern economic civilization. There is one word for this: It is insane.
One last dig from Munger (from 2011):
Greenspan was a smart guy but he totally overdosed on Any Rand when he was young. You can't give bankers the freedom to create gambling games. That's what it was. Wall Street was a gambling house, and the house's odds were better than a Vegas casino. And real casino operators have to build parking lots, fly in entertainers, pay for bars and restaurants. It's expensive. Wall Street was like a casino with no overhead. It was hog heaven for them. But it created vast damage with terrible consequences to civilization.
What about Buffett? In his 2009 letter to shareholders, he went off on derivatives:
Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks ... Improved "transparency" -- a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks -- won't cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can't audit these contracts, and regulators can't regulate them. When I read the pages of "disclosure" in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don't know what is going on in their portfolios (and then I reach for some aspirin).
Lately, he's turned around completely. In January, Buffett told Bloomberg:
The banks will not get this country in trouble, I guarantee it. The capital ratios are huge, the excesses on the asset side have been largely cleared out.
In a separate interview earlier this month, Buffett spoke of Bank of America (NYSE:BAC):
I have no idea whether it's going to go up or down tomorrow or next week or next month or next year. But, they are making progress in getting rid of a lot of things that they shouldn't have been in. They're making progress on cleaning up mortgage problems from the past. Most of which came from their acquisition of Countrywide. They're doing the right things, and they've got a terrific low-cost deposit base. So over time, they will do well.
Of course, his record here is not infallible. In 2009, he wrote to shareholders:
I made some other already-recognizable errors as well. They were smaller, but unfortunately not that small. During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes "unforced errors."
Finally, in 1991, Buffett, then temporary CEO of Solomon Brothers amid a scandal, testified before Congress and mentioned a rule he held his banking employees to:
Lose money for the firm and I will be understanding. Lose a shred of reputation for the firm and I will be ruthless.
So it's a bit of a puzzle. Buffett and Munger are viciously critical of derivatives and the opaqueness they cause, yet invest in some of the largest derivative dealers. They are critical of banks' morality, yet appear to grant a waiver for immorality committed at banks they own shares of.
I don't doubt that many of the big banks will make great investments, particularly at the terms Berkshire invests at. But what should you pay attention to: Buffett and Mugner's words, or their actions? The two can be far apart.