OTC Derivatives and the "Buffett Amendment" (Update 1)

rc whalen's picture

There is a lot of news this week on financials coming from Washington and the noise level is drowning out some of the detail.  So when I heard that Berkshire Hathaway (BRK) CEO Warren Buffett was trying to slip an exception into the substitute legislation offered by Senator Blanche Lincoln (D-AK) to give his OTC derivatives book special treatment, I put aside my book project and picked up the short sword. 

The "Buffett Amendment" would have exempted all of the existing OTC derivatives contracts from the new collateral requirements in the financial reform legislation.  The fact that such a ruse was even necessary illustrates why we need to drive a wooden stake through the heart of OTC securities and derivatives, namely that some of the biggest corporates in the world are allowed to play at the roulette table without buying chips.  The "AAA" rated BRK, Caterpillar (CAT) and the other big corporates can trade OTC without posting any collateral or initial margin. 

What's wrong with this picture?

When you trade on a derivatives exchange, all of the customers must post margin.  It does not matter whether you are Warren Buffett or Lloyd Blankfein or Joe Sixpack, you must "show us the money."  But apparently Warren Buffett, the man who once called OTC derivatives "weapons of mass destruction," now needs to supplement BRK earnings by trading OTC derivatives without any collateral backing up the trades.  Hmm.

Now we know why BRK, CAT and the other big corporate came oozing out of the woodwork last year to defend the OTC derivatives market.  JPMorgan (JPM), Goldman Sachs (GS) and the other OTC dealers let Warren Buffett and the other "AAA" corporates play at the roulette table w/o any chips.  Wouldn't you like to be able to sit at the big table and play poker alongside Mr. Buffett w/o actually putting up any cash to back your bets? 

The best part of all is that Mr. Buffett called upon US Senator Ben Nelson (D-NE) to create a derivatives loophole that would benefit his company to the
tune of billions, a proposal Senate Democrats quickly quashed. Nelson was the insurance commissioner of NE prior to coming to Washington, so you could say that Nelson is a "previously owned" Republican.  It is my impression from speaking to members of both parties in Congress that Nelson is viewed as a complete idiot by his peers in the Senate.  Maybe the Sage of Omaha needs to find a new boy to carry his dirty laundry.  Do you think?

In any event, keep an eye on Mr. Buffett and the gang who populate the BRK CSUITE.  Despite their protestation of being conservative, "fundamental value" investors, it seem that Buffett and Co. are no different from the OTC derivatives dealer banks which enable his derivatives speculation.

And in case you find this opinion a little harsh, just remember that Mr. Buffett and his colleagues at BRK are the same folks who have been sanctioned by the SEC on several occasions for aiding and abetting the manipulation of corporate earnings using side letters and other canards taken from the insurance markets.  The use of side letters in the case of American International Group (AIG) to falsify corporate financial statements is the functional equivalent of using OTC derivatives sans collateral or initial margin to goose BRK earnings.  Do we see a pattern forming perhaps? 

But of course the Big Media is probably going to ignore this story tomorrow.  Other than a mention on WSJ (Damian Paletta who broke the story), CNBC earlier today (kudos to Michelle Caruso-Cabrera for enjoying the moment so) and MarketPlace radio, there has been virtually no press coverage of the Buffett Amendment.

I am attaching the revised OTC derivatives amendment that Chris Dodd (D-CT) and Senator Lincoln hope to put into the financial reform bill this week. One of these days I will tell you how Chris Dodd worked his way through "high" school.  Is this a great country or what?

Be well -- Chris




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gs_runsthiscountry's picture

Let us review some of Warren Buffets words of wisdom and famous quotes:

"Derivatives are financial weapons of mass destruction."

"When you combine ignorance and leverage, you get some pretty interesting results."

"I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over."

"Someone's sitting in the shade today because someone planted a tree a long time ago."

"Only when the tide goes out do you discover who's been swimming naked."

"It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently."


Can you say poetic! Mr Buffett, please review your last quote. Live it, learn it and dont feed us all the hypocrisy.


That is all...




Thomas's picture

I'm on record with my negative opinion of Buffet (albeit understated)...


exportbank's picture

Mitchman has it right..

Insurable Interest - is the key.

chindit13's picture

As yardfarmer above noted, this is not new.  Yardfarmer posts the gains for 2009 for BRK---all with zero collateral---do the math on that ROA---of $486 million.  I'll search for it, but seem to recall 2008 was $975 million.

"Weapons of mass financial destuction" indeed, Warren!  Turns out you're an arms merchant.

Rick64's picture

Warren Buffet, the man who once called OTC derivatives "weapons of mass destruction,"

 Don't pay any attention to what they say, watch what they do. 

 Actions speak louder than words.

The Alarmist's picture

Even if it is gambling, so what? Our wise elders at Treasury seem to have more concern about the failure fully to deliver on the CDSs than the counterparties in the trades themselves, as AIG's counterparties themselves seemed at the time to be fully prepared to take the haircut.

My own belief is that you could let $600T of CDSs go belly up and at the end of the day, when the dust settled, roughly $6B of real cash would change hands to settle everybody up.  Look at the typical settlement on a CDS and tell me how much money actually changes hands in a so-called "normal" environment.

As for collateral requirements, all it serves to do is to suck the money out of the pockets and portfolios of those who supply capital (you, me, pension funds) and put it firmly into the hands of those who take capital or collect a toll on its way from us to them.

Oh yeah, and Chris Dodd's wife is on the Board of the CME, which stands to gain greatly if derivatives trade is directed to exchanges.   

Augustus's picture

I believe the gross notational amount for the Lehman CDS settlements were about that $600 Bln.  And you may be pretty darned close on the settlement number.

The AIG problem was a good bit different in that they wrote a whole lot more insurance than they bought, different from a trading firm.

Cursive's picture

Chris Whalen reads a lot better on Zero Hedge than on TBP.  Do you think if Becky Quick passes MCC in the hallway it could lead to a cat fight over Buffy?

percolator's picture

I'm so sick of Warren, its about time that crook starts pushin' daisies, though I'd prefer to see him rotting the rest of his few years left on this planet in prison where he belongs.

Yardfarmer's picture

I suppose that BRK $486 million in after tax profits on OTC derivatives in 2009 and $3.4 million in lobbying can stuff a lot of pockets. the so called financial reform bill will go the way of the Volkcer rule and all similar congressional window dressing. great post. brief and insightful.

Miles Kendig's picture

Chris, your writing has been energized recently... Hoowa

onlooker's picture

A Business Degree in 1962 has been of little use in attempting to digest today’s $ World. Fortunately (I think) I ran across your folks a few months back and have been working at dialing in on the situation, assisted by some of your stellar observations and data. Beside the confirmation of my distrust in the system, I am astounded by the lack of understanding--- by almost everyone it seems. Based and Biased upon that, I predict that the squid and the other predatory “wealth management” companies will survive nicely for a while. However, if you guys also survive, there will be progress made. This is a revolt in the very early stages and thanks to the web; suppression of information is much more difficult than in past decades. But, the big boys are doing a pretty good job.

Kayman's picture

To Onlooker:

Actually, a bunch of the "big boys" have gone bust and the remaining dinosaurs are stumbling around blinded by their greed.  I have always called it "drinking their own bathwater."  Those who promote themselves as pristine pure, ultimately smell like a sewer.

The Giant Squid is drowning in its own effluent. Keep watching.  All the banks will be busted up into smaller packages. If not this year, then just before or after the next Presidential election.

Best regards.

mindscratch's picture

Nelson is a Democrat

Augustus's picture

He justified his vote against cloture (effectively passage) by stating that he had not been able to read the bill.  My guess is that he HAD read the note from Uncle Warren.

Catullus's picture

Hold on there.  Driving a stake through all OTC derivatives is wholly unnecessary.  The electric power industry, the mining industry, farming, and most energy E&Ps don't need to put their hedging activities on an exchange. 

It's obvious what's going on.  Pushing derivatives to an exchange will either force these companies to post collateral or engage in collateral arrangements with banks that wrote this piece of legislation.  So every gallon of gas you pump, every time you flip on the tv, every high fructose corn syrup candy you eat, a bank gets paid for no other reason than they have a printing press backing them.  And when they want to monetize debt, they'll send the economy into a tailspin, force a whole host of companies to violate the unreadable covenants in the collateral arrangements and declare they own the companies. 

cbaba's picture

I strongly disagree with you.

All of the derivatives are gambling, you think the companies decrease their risk by doing so, so the game should go on,

but who pays the price ? we, tax payers by bailing out the AIG and other agents playing in this game as the casino owner but has no money to pay in case of default..

.. and not just paying little extra for a gasoline but losing everything, all our savings. people lose their jobs, lose their peace of minds, devastates the society.



Catullus's picture

Augustus addressed most of the response.  But I'm going to drive it home further. 

If I'm a farmer, or small oil exploration company, or power plant, I want to make some revenue guarantees by locking prices for a period of time.  I do so by selling forward supply of a good that I produce knowing that I will be able absent an act of god of delivering on that obligation.  When I sell forward, I'm short the market.  I can decide to hedge the entrepreneurial estimation I've made by purchasing calls (a speculative position that the market will rise; of which there is someone on the other side willing to bet that the market price will not rise to that level) to offset my inherent short position.  Or I can purchase calls on input prices to ensure cost containment for critical functions of my business. 

This is legitimate hedging and it is not gambling.  But this piece of legislation is not addressing whether this is gambling or not.  This piece of legislation is saying when I make these transactions or contracts, I must go to an exchange.  And in doing so, I can't make a bi-lateral agreement with someone else.  Normally what I would do is use my plant, equipment, or land as collateral to back my bi-lateral agreement.  But now since the transaction must be standardized to fit the exchange, I must now post cash as collateral. 

Where do I get this cash from?  I either have to sell equity, take out a loan (banks win), or arrange for a collateral posting arrangement with a bank.  I could have used this cash to purchase more equipment or hire another worker or just paid my original working capital arrangements off sooner, but now I have to use it to post collateral on a exchange that I was capable of performing elsewhere or Over The Counter. 

So I'm missing the point where posting my equipment or land as collateral for hedging is so devastating to society.  And yes, there may be "speculators" on the other side of the trades I'm making, but so what?  So long as they fulfill their obligations to the transaction, I can have stability in the prices in which I sell and in the input costs of raw materials I purchase.  

cbaba's picture

Hi Catullus ;


There is a risk and you want to hedge it, i understand but you are pushing the risk to another person, you dont care who buys that transaction. but in fact the risk always remains, it never goes away.So there is always a risk cost from your position.

You have to put a collateral, and you  should take that risk of your promise, transaction,  cash is the best.

Yes your equipment, land may also work but there are cases it will worth nothing.

Your equipment may cost you millions of dolars but when you try to sell in  a recession you may not even find a buyer for 10% of your buying cost, besides your equipment has been used, its depreciated its value.

Land price is fully speculated ..also depend on the location, market demand. Its hard to sell it quickly, there is a time constraint .

As you said there is someone on the other side willing to bet that the market price will not rise to that level, and thats called gambling in my language. Officially its not , i know but for me ethically its gambling.

If the amount of trade is big, there will not be enough gamblers on the other side and then the GS and other big bankers join in the game, they have a lot of cash,courtesy of FED, but they want to make money too and they are smart as sob, they will never lose money so they package this risk, rate it Super A* and sell it to other pension funds, investors who believe there is no risk at all , Or they buy insurance for their products from entities guaranteed to fail like AIG .

Its a shell game, they never loose and when the hell brokes goverment intervenes and saves AIG , bails them out. Economy collapses. This is what happened, nobody has a skin in the game.

So now your risk becomes everybodys risk. Bankers get away with it. but we have to pay the price of your risk.




if's picture

The cost of a collateral loan backed by your production assets should be minimal.  Why should it be free if the cost of money is not free ?  Hedging typically costs you some of your profit while offloading some of your risk.  Any other solution amounts to a taxpayer subsidy which distorts markets at best.

Augustus's picture

If I buy Girl Scout cookies and agree to pay a particular price for them when delivered, what should the collateral be?  On which exchange should it be traded.   Please detail the taxpayer subsidy involved.  Thanks.

The people trying to write this legislation don't have a clue as to how the agreements are made or used.  Chris Dodd?  Barry Obama?  Harry Reid?  They should have to take their retirement in FNM shares priced at the high.

cbaba's picture

Hi Augustus;

why do you need a fixed price, let it fluctuate if you cannot fix the price.

Dont underestimate the other people just by saying they dont know anything, may be they know more than you.

What happened to this country , its falling part, what was wrong?

Augustus's picture


you may disagree, but you don't understand the issue he is addressing.  The producer has a contract to deliver the grain, gas, oil, or electricity.  Then they agree on a price for January, March and June deliveries.  That is a futures contract and would require margin and margin adjustments under the legislation.  It does not work that way in the real world.  The producer delivers the product for the agreed price, without regard to the market price at the time, and it is settled.

The whole AIG deal is and was an aberation being used to bring Govt control to every financial transaction.  There was no law or insurance fund that was intended to be used by the govt. for the AIG purposes.  They just made it up and paid off 100%.  If AIG had gone down immediately it would not have necessarily brought down the insurance companies as they were regulated with seperate resrves.  They may have been even better as they would have been immediately sold off to a stronger company to operate.

I was a long time ago but I've trade ginnies on a when issued basis several months out with no margin.  They knew our business and we knew something of theirs.  Trades close with delivery and no screwing around with margin.

Mitchman's picture

Why can't we just have the concept of "insurable interest" the way that we do in life insurance?  You can't buy a policy on someone's life, make yourself the beneficiary go out and kill the person and then collect. Why can't derivatives be handled the same way? Commodity derivatives existed that way for many years, didn't they? 

Gromit's picture

Berkshire will have difficulty performing on its short put positions if it is obligated to do so because the rest of its assets are oriented long.

You don't stress test an umbrella on a sunny day.

overmedicatedundersexed's picture

buffet will just have moody's start downgrading the competition (in this case the whole GD market)..he holds that bazooka ..no one messes with warren.