Warren on Gambling with derivatives

WARREN BUFFETT: Carol.

CAROL LOOMIS: This question is about derivatives.

“What useful function do derivatives serve in our economy? We got along quite well without them for many years. If they serve no useful purpose, and in fact, have demonstrated that they can do considerable damage to the economy, why are they not made illegal, especially the naked ones? There is precedent for that.

“I believe that short selling of stocks that one does not own or has managed to borrow is illegal.”

WARREN BUFFETT: Charlie has — he can get worked up more on this than I can, so I’m going to let him answer that. (Laughs)

CHARLIE MUNGER: Well, I think the usefulness of derivatives has always been overrated. If we didn’t have any derivatives at all, including contracts to buy and sell grain that were traded on exchanges, we’d still have plenty of oats and wheat.

I mean, I think it is slightly more convenient for people to be able to hedge their risks of farming by using derivative markets and commodities.

And the test is not, “Is there any benefit in derivatives?” The question is, is the net benefit versus disadvantage from derivatives useful? Or would we be better off without it?

My own view is that, if we went back to having nothing but derivative trading in commodities, metals, currencies, safely conducted under responsible rules, and all other derivatives contracts vanished from the earth, it would be a better place. (Applause)

WARREN BUFFETT: We’ll take a current example. Burlington Northern has hedged diesel fuel, which they use a lot of, over the years. And then they also have fuel adjustment clauses in a lot of their contracts for transportation.

With Matt Rose, who does a wonderful job of running Burlington, I basically say, “Look at. If I were running the place, I wouldn’t bother to hedge them,” because if you hedge it — if you hedge it for a million years, you know, you’re going to be out the frictional costs, probably, of doing it, unless you’re smarter than the market generally on diesel fuel. And if you’re smarter than the market on diesel fuel generally, we’ll go into the business of speculating on diesel fuel.

I mean, if we’ve really got an edge, you know, why bother to run the trains? Let’s just speculate diesel fuel.

But I also say, you know, they’ve got — and if you have an organization where you have somebody in charge of that activity, it’s going to take place.

On the other hand, Matt Rose has done a fabulous job, as well as his management team, in running Burlington Northern. If they are more comfortable, or they find it useful in any way, in terms of pricing contracts, or anything, to hedge it, that’s fine with me, too.

I mean, it’s his company, he can figure out the best way of running it. I’ll hold him responsible for how it does over time. And, you know, I would do it one way and somebody else would do it another way. I don’t think that’s —

I would not condemn anybody that’s running a railroad for hedging diesel fuel, nor would I condemn anybody that runs an energy company, like we do at MidAmerican, for hedging energy costs in certain ways.

But I do think, if we could put up a presentation, number 4 on the screen, please.

I think it was said very well in 1935. In fact, chapter 8 of Keynes’s General — chapter 12, I’m sorry — chapter 12 of Keynes’s “General Theory” is, by far, in my view, probably Charlie’s too, the best description of the way capital markets function, the real way people operate. It’s prescriptive, it’s descriptive.

Everybody should read chapter 12. It’s a little — it starts a little slow in the first few pages.

But Keynes — I’m going to read this because I don’t think Charlie has it in front of him.

The first part of it is very familiar to people. I mean, this quote has been used a lot. But every word in this, to me, is right on the money.

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.”

You can change that to “gambling” if you want to.

“When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” That’s the famous part of the quote.

Keynes went on to say, “The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism - which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.”