Financial WMD

It is now six years since Warren Buffett wrote his famous description of derivatives as ‘financial weapons of mass destruction’ – a phrase that is now quoted left, right an centre. It comes from his summary of his company’s investment strategy:

We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal (Berkshire Hathaway, Annual Report, 2002: 16).

By and large, this is all you ever read about Buffett famous words – a splendidly resonant phrase. But after a quarter of a century in serious research, I have found that there’s nothing quite like going back to the source. So if you read the report in full (come on, it’s only 78 pages, well written and strangely human for a business document – I rather like the author), you will find an astonishing critique of contemporary business practices, especially among the investment houses. Here are a few of his more striking words from 2002:

Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge… (pp.15-16)

Accountability and stewardship withered in the last decade, becoming qualities deemed of little importance by those caught up in the Great Bubble. As stock prices went up, the behavioral norms of managers went down. By the late ’90s, as a result, CEOs who traveled the high road did not encounter heavy traffic.

Most CEOs, it should be noted, are men and women you would be happy to have as trustees for your children’s assets or as next-door neighbors. Too many of these people, however, have in recent years behaved badly at the office, fudging numbers and drawing obscene pay for mediocre business achievements. These otherwise decent people simply followed the career path of Mae West: “I was Snow White but I drifted.”

In theory, corporate boards should have prevented this deterioration of conduct. I last wrote about the responsibilities of directors in the 1993 annual report… There, I said that “If able but greedy managers overreach and try to dip too deeply into the shareholders’ pockets, directors must slap their hands.” Since I wrote that, over-reaching has become common but few hands have been slapped. (p.16)

This is followed by a severe critique of allegedly ‘independent’ directors (p.18-20), of whom he declares that ‘their record has been absolutely pathetic’ (p.18), and an insistence that most investment managers perform at a mediocre level (a claim that research bears out fully) but over-paid. Perhaps most strikingly of all are Buffett’s business principle no.7 - ‘We will reject interesting opportunities rather than over-leverage our balance sheet’ (p.70). His preference for a fair price over a high one (p.72) and his attachment to ‘intrinsic value’ (p.73) are pretty striking too.

Unfortunately, having captured the effects exactly, Buffett get the causes quite wrong. He insists that the main cause of this is the difficulty of asking for a mediocre CEO to be fired when you are a member of the same little club, ‘the board’. In other words, the problem is essentially one of good manners.

Well, at least he isn’t going on about personal greed exclusively. Like greed and irresponsibility, weak governance and social constraints do indeed prevent decisive action from being taken. But if the present situation – not to mention to repeated mis-selling scandals – makes perfectly clear is that problem is actually systematic – and that the ‘system’ at fault is market capitalism itself.

Or rather, it is not market capitalism, because another thing these scandals and crises have made clear is that few contemporary ‘markets’ are any such thing. Rather, it is capitalism as such, which if not regulated and, where appropriate, directed and firmly controlled, simply demands the maximisation of profit by whatever means possible. It may help in such circumstances to have a lot of greedy people running the show – people how can be relied upon to maximise their own returns. But as the behaviour of the companies themselves has demonstrated time and time again, this is quite in line with the company board’s own goals.

Perhaps it is worth recalling another major scandal of recent years – the fall of Enron, Global Crossing, Worldcom and above all Arthur Andersen. Perhaps it is an urban myth, but I distinctly recall hearing that the most common response of many figures in the City to their tame Andersen partner was ‘Why didn’t you do that for us?’

This crisis is not about greed or poor internal governance. This is the normal operations of capitalism when it gets to decide its own rules. We would do extremely well not to forget this – and, if necessary, consider alternative arrangements.