'Warren Buffett does not practice what he preaches'
Satyajit Das, an expert on the financial markets and derivatives, tells us why financial TV is pornography, and why Buffett is not always what he seems.
SatyajitDasis an internationally renowned derivatives expert.His works include the best-selling Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives. His latest bookExtreme Money - Masters of the Universe and the Cult of Riskdeals with the messy details of the 2008 financial crisis, the lessons from which have still not been learnt, feelsDas. As he puts it, "We keep repeating the same mistakes over and over...The only lesson of history after all is that no one learns the lessons of history."
In this freewheeling interview with Vivek Kaul, he talks about how investing is never going to be the same again, why financial TV is pornography, and that Warren Buffett does not practice what he preaches.The interview will be published in two parts. This is the first part.
Why do you call "financial TV" pornography?
Pornography is formulaic, explicit subject matter is depicted to sexually excite the viewer. Financial TV shares the characteristics of pornography - sleaze, intrusiveness and a desire to titillate and shock. It is a 24/7 Joycean stream of consciousness, a financial noise machine with the inevitability and repetition of all sexual congress. No one seriously relies on financial TV for deep insight. If it is on TV, then it's already happened. It's entertainment. Attractive men and women cater to all possible proclivities in the audience. It's like wall paper or eye candy - pleasant but not essential. In dealing rooms, generally you don't even have the sound on, so it is like pornography in another sense - dialogue is superfluous. The only time financial TV is interesting is when I am invited on to offer my money making insights - buy low, sell high etc.
You say that investment genius was always little more than a short memory and a rising market? You write that the assumed sophistication of finance and financiers is overrated. Why do you say that?
Investing is like captaining a cricket side - 90 percent luck and 10 percent skill, in the words of former Australian Test captain Richie Benaud. But as he said, don't try it without the 10 percent! The last 30 years were an exceptional period of investment history which provided high returns for reasons which are unique to that period. The best investment strategy would have been to buy stock or real estate and leverage it up. Then go to sleep or play golf for 25 years. You would have been a rich man.
When people make money, they theorise too much about it - hence all the books about trading success. The latest fad is about explaining the trader's personality via his biology. Some research suggests that male traders perform better when they have elevated testosterone levels. As prices increase and decrease, traders experience chemical changes. Euphoria caused by boosted testosterone levels from successful trades drives higher risk taking. Losses or reversals increase levels of the defensive steroid cortisone leading to risk-aversion. The experimental data is thin.
Could you elaborate on that?
If correct, you could take steps on banks and fund managers to manage risk. You could artificially manipulate the biology of traders and investment managers to improve performance. It is not hard to imagine a future where traders will need to have their supplements -uppers and downers (in the old parlance) - at hand to improve trading, similar to the experience of competitive sports where drugs have become relatively commonplace to improve performance. It is also not hard to imagine internal risk mangers and regulators insisting on regular monitoring of hormone levels as part of the compliance regime, with attendant cheating.
Isn't that far fetched?
This is not far-fetched. Already, organisations are adopting unusual initiatives to gain a critical edge. A trader at Steve Cohen's SAC Capital was allegedly forced by his boss to take female hormones and wear articles of women's clothing at work, leading to a sexual relationship between the men, one of whom was married. The bizarre behaviour was to eliminate the trader's aggressive male attitude, making him a more obedient and detail-oriented trader. How can you take an industry which actually does this seriously!
Does Warren Buffett practice what he preaches?
Talking about Warren Buffett is like discussing the existence of God. He is either great or he is not (the minority view). I am an atheist. Whatever his record as an investor, there are differences between Buffett's pronouncements about the standard of conduct he requires of others and that he follows. While he dispenses finely crafted criticism of derivatives as weapons of mass destruction, Berkshire Hathaway (Buffett's holding company) makes extensive use of derivatives and invested in Salomon Brothers and General Reinsurance, both participants in derivative markets.
During the crisis, Buffett, a significant investor in Moody's, was silent about the problems surrounding rating agencies. Having uncharacteristically declined an invitation to appear in June 2010, Buffett testified before the Financial Crisis Inquiry Commission under subpoena. Buffett emphasised that he knew little about the rating process other than its profit margins. He had never visited Moody's offices, not even knowing where they were located. He also defended Moody's not acknowledging any failure or complicity of the agencies in creating the bubble. When Goldman Sachs was indicted for alleged violations in structuring and selling CDOs (collateralised debt obligations, a kind of security backed by loans and bonds), Buffett, a major investor in Goldman, defended the firm, its actions and its CEO.
Could you tell us a little more about this?
Critics have frequently pointed out anomalies in the firm's corporate practices. Berkshire Hathaway's dual-class share arrangement gives Buffett voting control whilst owning 34 percent of the equity. Until a decade ago, Berkshire Hathaway's seven-person board of directors consisted of mainly insiders such as Buffett's son. The new 'independent' directors include Bill Gates, a close friend of Buffett, and his regular bridge partner, as well as co-investor in the Gates Foundation. Critics also pointed to that fact Buffett's partner Charlie Munger's family owned a 3 percent stake in BYD, the Chinese electric battery maker, before Berkshire bought a stake in 2008.
As to his record as an investor, there are a number of interesting aspects. Firstly, what is the right benchmark to measure his performance against - it can't be the broad market index. Secondly, the source of his investment success is not that complicated. His main source of investment capital is the premium income from his insurance businesses (cash received today against a promise to honour a future contingent claim). This provides him with effective economic leverage (at low interest cost) to buy low beta assets. The strategy worked well but whether it will continue to work is more difficult. The past, as they say, is "another country".
In your book Extreme Money you write "Archimedes said, "Give me a lever long enough and a fulcrum on which to place it, and I shall move the world." You paraphrase it to write "give me enough debt and I shall make you all the money in the world". Can you elaborate?
Borrowing amplifies economic growth. Debt allows society to borrow from the future. It accelerates consumption and investment spending, as borrowed money is used to purchase something today against the promise of paying back the borrowing in the future. Spending that would have taken place normally over a period of years is accelerated because of the availability of cheap borrowing. In this way, debt generates economic growth. In financial markets, debt and leverage amplify returns.
Could you explain this through an example?
Assume an investor uses $20 of its own money - equity - and borrows $80 (80 percent of the value) to purchase an asset for $100. If the asset increases in value by 10 percent to $110, then the investor's equity increases on paper to $30 ($110 minus the fixed amount of debt of $80). If the investor maintains its leverage at 5 times then it can buy $150 of assets (funded by $30 of equity and $120 of debt). If the investor can now leverage 6 times then it can buy $180 of assets (funded by $30 of equity and $150 of debt). The investor still only has his original $20 investment in cash, unless he sells the asset to realise paper gains, which can vanish.
But now, this $20 supports even more debt, as much as $160 (the $180 of assets that the investor can buy if it leverages six times less its original investment). The real leverage is around nine times, which means an 11 percent fall in the value of the asset purchased can wipe out the investor's wealth entirely. Where the supply of assets does not increase as quickly as the supply of debt, the price increases allow the process to continue. In the period to 2007, the use of leverage, in different ways, to make money was rampant. Unfortunately, it was never real money. Of course, when prices start to fall the entire process operates in reverse.
Vivek Kaul is a writer. He can be reached at email@example.com
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