02 March 2009
Published in: Risk governance
The CEO must be the CRO, says Buffett
Berkshire Hathaway chairman Warren Buffett reveals in his annual letter to shareholders that his company is party to 251 derivatives contracts, despite maintaining his long-standing distaste for these products and reiterating earlier in his letter, "Derivatives are dangerous".
He gives a simple reason for entering into these contracts: "I believe each contract we own was mispriced at inception, sometimes dramatically so." He continues, "I both initiated these positions and monitor them, a set of responsibilities consistent with my belief that the CEO of any large financial organisation must be the Chief Risk Officer as well."
And he adds, "If we lose money on our derivatives, it will be my fault."
He claims Berkshire has assumed no significant counterparty risk through its derivatives deals because the ones it has entered into "require our counterparties to make payments to us when contracts are initiated. Berkshire therefore always holds the money."
Berkshire's book value performance in 2008 was the worst in its 44-year history. "Our decrease (Buffett's emphasis) in net worth during 2008 was $11.5bn," he starts his letter, which as usual is peppered with perceptive observations and dry humour. Long-term, Buffett remains optimistic on the US economy and markets. "America's best days lie ahead," he believes. But he admits "the economy will be in shambles throughout 2009 - and, for that matter, well beyond."
Reinsurance is a business of long-term promises Buffett tells us but the crucial point rammed home by 2008 was: "A promise is no better than the person or institution making it." Cue General Re, "the only reinsurer that is backed by a AAA corporation," he boasts. Buffett quotes Ben Franklin as saying, "It's difficult for an empty sack to stand upright," and adds, "That's no worry for General Re clients."
Buffett comments at length on what led to the housing crisis, and he reminds us that he and his family have lived in the same home for 50 years. His conclusion: "Putting people into homes, though a desirable goal, shouldn't be our country's primary objective. Keeping them in their homes should be the ambition."
On tax-exempt bonds, Buffett describes how Berkshire's offer to take over from the three largest monolines all of the insurance they'd issued on these bonds was rejected last year. He then describes how his company has since made a lot of money in the secondary market. Berkshire wrote about $15.6bn of business, 77% of which was on bonds that were already insured, mostly by the three monolines. As Buffett relished pointing out: "We wrote this ‘second-to-pay' insurance for rates averaging 3.3%. That's right; we have been paid more for becoming the second to pay than the 1.5% we would have earlier charged to be the first to pay." Berkshire even agreed to be fourth to pay on one deal and still got about three times the 1% premium charged by the monoline that is first to pay.
But he ends his ruminations on tax-exempts with a warning. Because local governments are facing significant fiscal problems and because solving these problems may well harm bond-holders' interests, insuring tax-exempts, Buffett says, "has the look today of a dangerous business - one with similarities, in fact, to the insuring of natural catastrophes. In both cases, a string of loss-free years can be followed by a devastating experience that more than wipes out all earlier profits."