Scrooge McBuffett's silver in the attic
By John Dizard
Financial Times; Mar 07, 2003
Here it goes:
search.ft.com.
I know you're not supposed to ask this sort of question of sages, let alone the Sage of Omaha, but is it possible that Warren Buffett is talking his own book? Promoting the value of his own holdings with his free advice to the public?
I'm referring to the doomsday comments the Berkshire Hathaway chairman has been making, most recently in Fortune Magazine, on the risks of derivatives.
In his Fortune piece Mr Buffett said he and his lead partner, Charlie Munger, had decided to dispose as quickly as possible of a derivatives book they had acquired when purchasing Gen Re, their reinsurance company. Ruefully, Mr Buffett admitted it would take years to get rid of it.
However, we know that in other parts of the Berkshire Hathaway attic there is at least one large pile of silver, and - who knows - possibly some gold bullion. (We can be pretty sure that if it exists, it's in the form of of the actual metal, rather than long-dated dealer calls.)
Unlike the Gen Re derivatives book, of which we can be confident that each position is offset by another, negatively correlated contract, the 4,000-tonne Berkshire Hathaway silver hoard is not offset by a short position.
Precious metals such as silver and gold were, historically, the way property owners hedged themselves against political and market disorder. In recent decades, derivatives contracts have supplanted precious metals as a way to offset risk.
They are a lot easier to carry around and better correlated with the price risks of the assets you want to hedge. For example, put options on US Treasury bonds are a much more precise way of offsetting losses from interest rate increases than are gold bars. And metal in your vault doesn't earn interest.
If, however, Financial Life As We Know It comes to an abrupt end, that 4,000-tonne silver hoard can be traded for a lot of low-priced equities, along with a reassuring quantity of 7.65mm ammunition, conveniently fitted with disintegrating links for any machine guns the company may have acquired by then.
Furthermore, if Berkshire Hathaway has been buying gold - and it would have to buy a lot before disclosure requirements kicked in - that would work out even better. In the meantime, Gen Re Securities derivatives should have booked profits more than sufficient to offset losses.
Berkshire Hathaway's purchase of its silver hoard was a huge event in the precious metal world when it was acquired back in 1997. It wasn't just the Scrooge McDuck size of the pile, it was the legitimising value of the Buffett name.
Since the collapse of the Hunt brothers' attempt to corner the silver market in 1979 and 1980, silver had gone down in prestige as well as price.
In the early 1990s I once asked a silver dealer what his customer base was like. "Well," he said, "one came in yesterday wearing a beard and a T-shirt with a picture of a Glock 9mm and the words, 'I DON'T CALL 911'."
See, Warren Buffett doesn't look at all like that.
I'm sure Berkshire Hathaway takes a longer view of the value of the silver hoard than many of the rest of us. Taking the midpoint of the price in the period during which the position was accumulated, the value of the position will have declined about 8 per cent in price, to which one must add the storage costs.
At the same time the equity bear market has taken the S&P 500 down about 12 per cent, which is offset by the dividends earned. Not a total disaster, but nothing to write home to Omaha about.
Mr Buffett does have some substantial concerns about the systemic risks of derivatives contracts, but he overstates his case. He asserts that the 1998 crisis exemplified by the problems of Long-Term Capital Management was caused by the firm's large holdings of derivatives contracts.
He overlooks other problems at the time, such as the collapse of the Russian government's finances. Also, while it took a while, LTCM's positions were, in the event, unwound.
Mr Buffett points a Ghost of Christmas Future finger at the market in credit derivatives such as credit default swaps. But the CDS market has, so far, performed well through the Enron, Global Crossing, Railtrack and WorldCom bankruptcies, with contracts paid out and defaulted bonds delivered in an orderly fashion.
There are legal issues in the derivatives market that should be sorted. "Master netting agreements", under which losses and gains in a variety of contracts can be offset, need to be granted a harbour from inclusion in US bankruptcy estates.
Passage of bankruptcy law reform, which looks more likely this year, would take care of that.
Oddly, Mr Buffett touts the value of the junk bond positions he has accumulated. I tend to agree with him about the values to be found in that market, but the legal or "systemic" problems are probably greater there than in the credit derivatives market.
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