In the immediate aftermath of the financial crisis of 2008, a common talking point was that this kind of "Black Swan" event could not have been predicted. It was a freak occurrence, with no warning signs. Of course, later on, many people would claim they foresaw the crash, but at the time it was unfolding, few were taking credit for having forecast it.
While only a small number of disparate individuals and groups predicted the crash correctly, there were a lot more people that sensed something was wrong. Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) were among these people. They were probably surprised that a crisis in the U.S. subprime mortgage market managed to topple the global financial system, but overall I think they could tell that something was about to happen. The Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) pair discussed financial derivatives at the 2007 annual shareholder meeting, foreshadowing some of the problems that were to come.
Weapons of mass destruction
Both Buffett and Munger have been on the record many times saying the most spectacular meltdowns are often the result of leverage. Derivatives like credit default swaps and collateralized debt obligations are a source of leverage because they magnify both the gains and losses of the holder.
But derivatives only really came into their own relatively recently. After the stock market crash of 1929, it was found that leverage played a big role in exacerbating the selloff. In essence, a lot of market participants had purchased stocks with borrowed money - on margin - and so, when the value of their holdings declined, they were hit by margin calls, which precipitated more selling and caused more margin calls, and so on.
Buffett believes the widespread use of financial derivatives from the 1980s onward made a mockery of these capital requirements. They made it possible for institutions to lever up whilst ostensibly respecting the old restrictions. Moreover, they resulted in an explosion in complexity, which made it difficult to predict how various inputs would affect the final output of the financial system. As he said:
“We may not know where exactly the danger begins and at what point it becomes a superdanger, and we certainly don’t know what will end it precisely, but probably it will go on and increase until at some point there will be some very unpleasant things happening”.
Buffett and Munger have called derivatives "weapons of mass destruction," referring both to their ability to decimate established financial systems and also to the unpredictability they introduce into the world. The analogy that Buffett drew was with World War I, when the assassination of Archduke Franz Ferdinand sparked the deadliest conflict in history. No one could have predicted that this exact event would set off the war, but the configuration of the Great Powers in 1914 had made it highly likely that something would trigger it. You don’t have to be a fortune teller to know when a situation is inherently dangerous, and this is what Buffett and Munger were able to see back in 2007.
Disclosure: The author owns no stocks mentioned.
Read more here:
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- Warren Buffett: Do Successful Investors Have to Be Math Geniuses?
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