Stanford Law Review has a great interview with Warren Buffett’s longstanding partner, Charlie Munger. Munger offers much less corn pone and more direct opinion than Buffett does.
The entire piece is very much worth reading, but I wanted to hone in on some key topics. One is the neglect of the role of what amounts to accounting fraud in this mess. Much of this is technically not fraud under the current regime but would be if the standards of 20 years ago were still in place. We now live in a world where everyone knows that the authorities simply will not take down any of the Big Four. Four is now deemed to be the minimum number of big accounting firms permissible. So we de facto have accounting firms “too big to fail”, which means “too big to be asked to eat much liability, not matter how indefensible their conduct.” So if they do something bad, they might have to fire a few partners and pay a moderate fine.
So effectively, we live in a world that echoes the Nixon Presidency. If the Big Four does it, it must be legal.
From the Stanford Law Review (hat tip reader Hubert):
As we look at the current situation, how much of the responsibility would you lay at the feet of the accounting profession?
I would argue that a majority of the horrors we face would not have happened if the accounting profession developed and enforced better accounting. They are way too liberal in providing the kind of accounting the financial promoters want. They’ve sold out, and they do not even realize that they’ve sold out.
Would you give an example of a particular accounting practice you find problematic?
Take derivative trading with mark-to-market accounting, which degenerates into mark-to-model. Two firms make a big derivative trade and the accountants on both sides show a large profit from the same trade.
And they can’t both be right. But both of them are following the rules.
Yes, and nobody is even bothered by the folly. It violates the most elemental principles of common sense. And the reasons they do it are: (1) there’s a demand for it from the financial promoters, (2) fixing the system is hard work, and (3) they are afraid that a sensible fix might create new responsibilities that cause new litigation risks for accountants….
Very few people realize how much we’ve screwed up. Even in leading law schools and business schools very few people realize that the mess at Enron never could have happened if accounting customs hadn’t been changed. What we have now is a bigger, more widespread Enron.
Munger also has some interesting observations about the decay in values:
Worse than the Great Depression?
The economy hasn’t contracted as much as during the Great Depression, but the malfeasance and silliness, the triggering events for today’s crisis, were much greater and more widespread. In the ’20s, a tiny class of people were financial promoters and a tiny class of people were buying securities. Today, it’s deep in the whole culture, and it is way more extreme. If sin and folly get punished appropriately, we’re in for a bad time….
The investment banks of yore, chastened by the ’30s, were private partnerships, or near equivalents. The partners were dependent for their retirement on the prosperity of the firms they left behind and the customs and culture they left behind, and the places were much more responsible and honorable. That ethos, by the time the year 2006 came along, had pretty well disappeared. Our regulators allowed the proprietary trading departments at investment banks to become hedge funds in disguise, using the “repo” system—one of the most extreme credit-granting systems ever devised. The amount of leverage was utterly awesome. The investment banks, to protect themselves, controlled, to some extent, the use of credit by customers that were hedge funds. But the internal hedge funds, owned by the investment banks, were subject to no effective credit control at all…..
How and why do you think economists have gotten this so wrong?
I would argue that the economists have not been all that good at working concepts of good and evil into their profession. Nor do they understand, at all well, the economic consequences of bad accounting.
In fact, they’ve made a profession of driving value judgments out of the subject.
Yes. They say it’s not economics if you think about the consequences of good and evil, and good and bad business accounting. I think what we’re learning is that when you don’t understand these consequences, you don’t have an adequately skilled profession. You have big gaps in what you need. You have a profession that’s like the man that Nietzsche ridiculed because he had a lame leg and was very proud of it. The economics profession has been proud of its lame leg.
There is also a good bit on why he and Warren have been so successful:
You’ve often said that one of the keys to your success has simply been to avoid making the garden-variety mistakes that you see other people make.
Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It’s not a competency if you don’t know the edge of it. And Warren and I are better at tuning out the standard stupidities. We’ve left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error.
If you had to characterize a few mistakes that you see executives making, which ones jump out at you?
An extreme optimism based on an inflated self-appraisal is one. I think that many CEOs get carried away into folly. They haven’t studied the past models of disaster enough and they’re not risk-averse enough. One of the very interesting things about Berkshire Hathaway is how chicken it is, how cautious, how low is its leverage.
I can’t speak for Berkshire overall, but that is certainly true of their reinsurance business. Ajit Jain is willing to sit around and do no business, even if he has to wait a couple of years, until, say, two hurricanes hit in 72 hours and the industry is desperate for reinsurance capacity and willing to pay big premiums. They are very disciplined and play only in “hard markets”.
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Berkshire, low leverage ?
Consolidated accounts @EOY08 shows 268 bln USD balance sheet, to which must be added (at least) 45 bln USD derivatives on risky underlyings (equities and high yield). All this with 110bln of equity. Doesn’t look low leverage to me ! And I am not even considering the undisclosed notional of maximum potential exposure arising from the Reinsurance business…
As we speak about reinsurance, it is worth having a look at the reserve determination process (especially on the IBNR side) :
– it uses management estimates,
– the two counter parties on each side of the transaction can (and frequently do) use completely different valuations.
Can someone explain to me how this is different from “mark to model” accounting ?
I always like seeing an apropos Nietzsche reference (most are wrongheaded and often slanderous).
Here’s some of what he wrote about what he called the “inverse cripples” (Thus Spoke Zarathustra Part 2, “On Redemption”):
There are people who have too little of everything and too much of one thing..
They are nothing but a big eye or a big mouth or a big belly or anything at all that is big. Inverse cripples I call them.
…The people, however, told me that this great ear was not only a human being but a great one, a genius. But I never believed the people when they spoke of great men.
Just bring GAAP back to pre-Reagan, apply it and then test, let the body’s fall were they may.
Neo-standard accounting/risk assessment reminds me of collage students thinking up NEW AND IMPROVED drinking games in order to keep binge drinking fun.
skippy…pass the SIV beer bong please, before reality sets back in.
To paraphrase Munger, "It is better to be sure than to be good." That's the difference between being Niki Lauda and Evel Knievel.
Big Accounting was already beyond dysfunctional twenty years ago. The S & L Crisis could never have gotten the traction it did if the accountants had blown whistles—but they didn't. That's what ten years of Republican moonshine does fer yah, then, in my opinion. Big Four = overconcentration. This is yet another reason why keeping participants in industries numerous, small, and diverse is good. Which takes regulation.
I agree with Munger on his concerns with the fictionalization of major corporate accounting. Think about almost anything during dot.bomb, and at the bottom of it were funny financials.
YS:
One of the few MSM people to complain about Big 87654 culpability for the current mess is Jonathan Weil at Bloomberg. I say bust the Big 87654 up into 16-20 smaller firms. The PCAOB is the opposite of what the public thinks. It’s the Big 87654’s cartel enforcer.
Sarbox turned out to be a Big 87654 fee bonanza. It should be repealed. Even the Sarbox CEO and CFO certifications are worthless. Securites fraud has been a crime since the 1930s.
I have said for years, just like TBTF banks, TBTF accounting firms exist. A small CPA firm which passed on stuff the Big 87654 do, would be put out of business by the PCAOB within a year. Trust me on this.
Original at:
http://www.law.stanford.edu/publications/stanford_lawyer/issues/80/pdfs/sl80_munger.pdf
Original also here:
"Behold, Zarathustra! Even the people learn from thee, and acquire faith in thy teaching: but for them to believe fully in thee, one thing is still needful–thou must first of all convince us cripples! Here hast thou now a fine selection, and verily, an opportunity with more than one forelock! The blind canst thou heal, and make the lame run; and from him who hath too much behind, couldst thou well, also, take away a little;–that, I think, would be the right method to make the cripples believe in Zarathustra!"
Zarathustra, however, answered thus unto him who so spake: When one taketh his hump from the hunchback, then doth one take from him his spirit–so do the people teach. And when one giveth the blind man eyes, then doth he see too many bad things on the earth: so that he curseth him who healed him. He, however, who maketh the lame man run, inflicteth upon him the greatest injury; for hardly can he run, when his vices run away with him–so do the people teach concerning cripples. And why should not Zarathustra also learn from the people, when the people learn from Zarathustra?
It is, however, the smallest thing unto me since I have been amongst men, to see one person lacking an eye, another an ear, and a third a leg, and that others have lost the tongue, or the nose, or the head.
I see and have seen worse things, and divers things so hideous, that I should neither like to speak of all matters, nor even keep silent about some of them: namely, men who lack everything, except that they have too much of one thing–men who are nothing more than a big eye, or a big mouth, or a big belly, or something else big,–reversed cripples, I call such men.
Also see: "Break, bleed, thou heart! Wander, thou leg! Thou wing, fly! Onward! upward! thou pain!" Well! Cheer up! O mine old heart: WOE SAITH: "HENCE! GO!"
Then see: —Here, however, Zarathustra could no longer restrain himself; he took his staff and struck the wailer with all his might. “Stop this,” cried he to him with wrathful laughter, “stop this, thou stage–player! Thou false coiner! Thou liar from the very heart! I know thee well!
I will soon make warm legs to thee, thou evil magician: I know well how— to make it hot for such as thou!”
—”Leave off,” said the old man, and sprang up from the ground, “strike me no more, O Zarathustra! I did it only for amusement!
> So why was it that Munger went along with having $30+ Billion in Goodwill accounting with Warren, which was obviously Level lll trash? The thing I dislike about this dude is that he speaks about honesty and ethics and then works at a company that has engaged in fraud — but that is a difficult concept, as I'm sure Spitzer can attest to!
This is for you Charlie, maybe you can learn something about yourself:
"Then was there again spoken unto me without voice: "Thou must yet become a child, and be without shame.
The pride of youth is still upon thee; late hast thou become young: but he who would become a child must surmount even his youth."
And I considered a long while, and trembled. At last, however, did I say what I had said at first. "I will not."
Then did a laughing take place all around me. Alas, how that laughing lacerated my bowels and cut into my heart!
And there was spoken unto me for the last time: "O Zarathustra, thy fruits are ripe, but thou art not ripe for thy fruits!
So must thou go again into solitude: for thou shalt yet become mellow."
>> "The Stillest Hour"
“They are very disciplined and play only in “hard markets”
Value investing is very hard, and the reason it is makes me doubt the efficacy of so-called “counter-cyclical” policies.
“the malfeasance and silliness, the triggering events for today’s crisis, were much greater and more widespread”
I agree with this, but also believe that it goes against arguments such as Winkler’s view that:
“Asset managers are more or less forced to seek higher interest rates through riskier investments.”
No one is forced into malfeasance and silliness. They are embraced by human beings for their own reasons and desires.
Don the libertarian Democrat
thx Liv!
Every time I read another article on the financial crisis I am struck by the extent to which packaging may have played a role in enabling reckless investor behaviour.
How many prospective homeowners would have approached a Bank on their own initiative to offer a novel deal by which they would pay no principal right now, interest only, but it would all come out right in the end. My guess is very few, but when the Banks started offering interest-only loans as a package, borrowers jumped at it.
How many corporate CFOs would have approached their CEOs with the bright idea of buying insurance on other companies’ bonds, and how many CEOs would have fired them on the spot if they had, but let a CDS market get created, with standard boilerplate contracts that anyone can buy, and it took off like a rocket.
Of course, package-ization is sometimes a healthy thing. A few decades ago trading options was a bespoke business that only a tiny number of boutique operations carried out, and today it’s routine retail business. A solid healthy business with no counter-party risk – that we know of.
It makes me wonder if maybe the Dutch tulip growers let the public into their market – to, you know, improve its liquidity, and give everyone a chance to profit – just before the whole thing blew up.
Yes, accountants are all total villains, but maybe just the act of making it easy to speculate should bear some of the blame.