Warren Buffett in 2002, loves collateralization:

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. ... Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).
Buffett in 2008: collateralization is a deal-breaker:
Only a small percentage of our contracts call for any posting of collateral when the market moves against us. Even under the chaotic conditions existing in last year’s fourth quarter, we had to post less than 1% of our securities portfolio. ... This is the only derivatives business [credit default swaps] we write that has any counterparty risk; the party that buys the contract from us must be good for the quarterly premiums it will owe us over the five years. We are unlikely to expand this business to any extent because most buyers of this protection now insist that the seller post collateral, and we will not enter into such an arrangement.
In other words, "collateralization for thee, but not for me." I'm fine with Buffett applying a double-standard to collateralization of derivatives; he is, after all, Warren Buffett.

11 comments:

jj said...

It's a big part of what got us into this mess in the first place ----lack of collateral.

Just because you're AAA rated , doesn't mean that will continue forever ... as AIG found out too easily

Economics of Contempt said...

Oh I very much agree that the vast majority of derivatives need to be collateralized, AAA rating or not. But if anyone should be allowed to choose whether or not to collateralize his derivatives, it's Buffett. At this point, I think he's earned the benefit of the doubt.

Anonymous said...

If you read the whole commentary it is clear that he is not assuming anything except minimal credit risk. His counterparties are the ones exposed which may explain Berkshire's recent CDS pricing. The essential point being collateralization is good if you are long options or itm contracts, collateralization is bad if you short non-linear derivatives.

jj said...

Buffett certainly deserves the benefit of the doubt .

BRK cds is now 495 , + 200 bp in 1 month ... that debt rating is at risk also

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