Last week, in our concluding article on Buffett's letter for the year 2000,
we discussed master's views on tendencies of certain CEOs to make lofty
projections of their companies' future earnings potential and the risks
associated with such projections. Let us now move on to accumulating wisdom
from the letter for the year 2002*.
In his 2002 letter, the master has devoted a fair deal of time and space to
the topic of derivatives. Infact, the master's prognosis on the risks
associated with derivatives come so perilously close to describing the
current US sub-prime crisis that one would be forgiven for assuming that Mr.
Buffett has access to a crystal ball.
*Derivatives: Devious or delightful?*
Much like most of the other inventions, derivatives too, were created for
the benefit of mankind in general and commerce and trade in particular. It
was especially helpful to smaller firms that did not have the capacity to
bear big risks. Derivatives enabled such firms to transfer some of these
risks to stronger, more mature hands. But again, like most of the other
inventions, derivatives can also be put to misuse. Abuse of the same, as has
become more frequent these days, could lead to dire consequences.
Furthermore, the very nature of a derivatives contract makes it risky to the
users. This is because unless accompanied by collaterals or guarantees, the
final value in a contract depends on the payment ability of the parties
involved.
The master is also of the opinion that since a lot of derivatives contract
don't expire for years and since they have to be provided for in a company's
accounts, manipulation could become a serious threat. For e.g.,
incorporating overly optimistic projections into a contract that does not
expire until say 2018 could lead to inflated earnings currently. However, if
the projections fail to materialize, they could lead to potential losses in
the future. In an era of short-term profit targets and incentives, such
measures result in higher CEO salaries. But they hurt long-term shareholder
value creation.
*This is what the master has to say on the issue:*
"Errors will usually be honest, reflecting only 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 part) on "earnings" calculated by
mark-to-market accounting. But often there is no real market (think about
our contract involving twins) 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 counterparties to use fanciful assumptions."
He further goes on to add "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."
Highlighting other dangers of derivatives, the master finally goes on to say
something that if central banks around the world, importantly the US Fed,
would have paid proper heed to, it could have been probably able to avert or
maybe minimize the enormous damage that is being caused by the US sub-prime
crisis.
We conclude the article with the reproduction of that comment.
*Weapons of mass destruction*
The master says, "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. Knowledge of how dangerous they are
has already permeated the electricity and gas businesses, in which the
eruption of major troubles caused the use of derivatives to diminish
dramatically. Elsewhere, however, the derivatives business continues to
expand unchecked. Central banks and governments have so far found no
effective way to control, or even monitor, the risks posed by these
contracts."
To read our previous discussion on Warren Buffett's letters to shareholders,
please click below:
**Since letter for the year 2001 is a little light on investment wisdom, we
have decided to omit the same.*
--
Disclaimer:
Some forward looking statements on projections, estimates, expectations &
outlook are included to enable a better comprehension of the Company
prospects. Actual results may, however, differ materially from those stated
on account of factors such as changes in government regulations, tax
regimes, economic developments within India and the countries within which
the Company conducts its business, exchange rate and interest rate
movements, impact of competing products and their pricing, product demand
and supply constraints. Nothing in this article is, or should be construed
as, investment advice.
No comments:
Post a Comment