This marks Warren Buffett’s 50th year publishing an annual letter of homespun wisdom and straight talk about his business. Despite his firm belief that you can’t teach a new dog old tricks, Buffett’s penchant for wry witticism was already in evidence at age thirty-five. “Our War on Poverty was successful in 1965,” he quipped. “Specifically, we were $12,304,060 less poor at the end of the year.” And although he (completely incorrectly) basked in the glow of having newly acquired a New England-based textile mill – “Berkshire [the textile business] is a delight to own” – Buffett’s investment record in the following five decades would be without parallel, over which period Berkshire [the conglomerate] would be an absolute delight to own.
Buffett has never been one to shy away from speaking frankly, even in criticizing himself or crediting fortune rather than skill. Consider these four examples, unlike anything you’ll ever read from almost any CEO:
- My analysis of USAir’s business was both superficial and wrong. In another context, a friend once asked me: “If you’re so rich, why aren’t you smart?” After reviewing my sorry performance with USAir, you may conclude he had a point. (1996)
- R. C. Willey will soon open in Reno. Before making this commitment, Bill and Scott again asked for my advice. Initially, I was pretty puffed up about the fact that they were consulting me. But then it dawned on me that the opinion of someone who is always wrong has its own special utility to decision makers. (2004)
- Except for a couple of favorable breaks, our pre-tax earnings last year would have been about $500 million less than we actually reported. We’re happy, nevertheless, to bank the excess. As Jack Benny once said upon receiving an award: “I don’t deserve this honor – but then, I have arthritis, and I don’t deserve that either.” (2002)
- Charlie and I make few predictions. One we will confidently offer, however, is that the future performance of Berkshire won’t come close to matching the performance of the past. (1994)
Yes, this CEO wrote in corporate missives over the years that you might conclude he wasn’t smart, that his judgment always failed in one area of business, that his company benefited from fortunate breaks, and that future returns would not match previous ones. No wonder so many trust him.
As we read Buffett’s golden anniversary edition, this passage caught our eyes right away:
We will never engage in operating or investment practices that can result in sudden demands for large sums … Some years ago, we became a party to certain derivative contracts that we believed were significantly mispriced and that had only minor collateral requirements. These have proved to be quite profitable. Recently, however, newly-written derivative contracts have required full collateralization. And that ended our interest in derivatives, regardless of what profit potential they might offer.
So Berkshire Hathaway, ranked in the top five for market capitalization, largely no longer writes derivatives contracts because of the margin features that are central to the global regulatory framework! It’s worth noting that Chatham strongly supports many of the systemic risk and transparency measures contained in Dodd-Frank and its equivalents around the world. However, as we read this passage, we couldn’t help but think of all the other companies whose operations have been hampered or diminished by derivatives regulation’s excesses and who don’t have Buffett’s rhetorical platform. As we speak daily with many such companies, these five significant concerns have emerged as key global challenges facing those that use derivatives to manage their risks:
(1) Narrow End User Exemption in the US: Regulators globally opted to apply the substantive economic requirements of derivatives regulation – clearing and margin – to financial entities, while nonfinancial end users can avail themselves of an end user exemption. Most countries have specifically defined “financial entity” by reference to specific regulatory classifications. For example, mutual funds, alternative investment funds, insurance companies and banks are among those that fit within the financial entity definitions in the US and Europe. However, the United States went one step further in Dodd-Frank, requiring any entity whose activities were predominantly financial in nature to be classified as financial entities. As a result, credit card processing companies, some leasing companies, mortgage REITs, non-bank lenders and even management consulting firms are treated as financial under Dodd-Frank and subject to significant margin requirements.
(2) Margin on FX Hedging: All alternative investment funds are encompassed within the financial entity definitions in the US and Europe. This includes not only hedge funds that invest in securities, but also real estate, private equity, infrastructure and microfinance funds that invest in physical assets or loans to the world’s poor and who do not hold the kinds of cash or securities necessary to meet margin requirements. Because clearing and margin requirements do not yet apply to foreign currency hedges, the economic burdens associated with these requirements have not yet taken effect. However, these requirements will serve as a key challenge and impediment to hedging for funds once these requirements take effect – expected as early as December 2015, although we anticipate regulators will soon announce an extension of this deadline by 6-12 months.
(3) Hedging Cost: While end users have now succeeded in advocating for a margin exemption for non-financial end users, capital and margin requirements imposed on swap dealers will increase the cost of hedging for end users, possibly significantly. This is because banks will require a return on the funds they set aside to meet capital and initial margin requirements, and they will get that return by raising transaction pricing. Since Europe offers an exemption for end user hedging in its capital requirements framework and because margin requirements have not yet taken effect, end users have by-and-large not yet experienced the higher pricing. However, this will be a key issue in the years ahead, likely between now and 2019. The minimum fixed costs associated with clearing already are an issue for some smaller financial entities, causing some clients to reevaluate or stop using over-the-counter derivatives.
(4) Reporting in Europe: New administrative burdens foisted on end users in the form of reporting requirements have been the most significant challenge to date. These burdens are lightest in the US, which requires reporting only by swap dealers and will not enforce requirements to report trades between affiliates within a corporate group. Companies transacting in Europe have faced the most significant burden, because Europe requires both parties to a trade to report dozens of data fields and offers no exemption for trades between affiliates. With companies having expended significant effort to comply with the reporting obligation, their most significant challenge at present is in ironing out data quality problems that might prevent reported trades from matching with and being reconciled to trades reported by dealers. While companies have reason to hope that regulatory enforcement will not focus on minor gaps in end user compliance, the inability to drive toward compliance perfection – sometimes a result of difficulties with swap data repositories – is a source of ongoing anxiety and compliance effort.
(5) Uncertainty: Even as end users have complied with numerous requirements in the US and Europe, the compliance journey isn’t finished yet. Requirements in the Asia Pacific region, as well as in Canada and Switzerland, have yet to be completed. It is anticipated that new rules will be proposed in 2015 requiring banks not to trade with end users if they haven’t given up their right of cross default when a bank holding company fails – a requirement which would likely be effected via an ISDA protocol. End users are still identifying regular business contracts that could be interpreted as derivatives, and subject to reporting and other requirements. Margin requirements are yet to be completed and will require significant attention in the coming year from some financial end users. Some companies are uncomfortably avoiding regulatory requirements by relying on no action relief – promises from regulatory staff that they won’t enforce or prosecute for non-compliance. Thus, companies remain uncertain about just how long and difficult the remainder of the compliance journey will be.
While many of our clients are eligible for the end user clearing exemption, which likely doesn’t apply to Berkshire Hathaway, regulation has made the prudent use of derivatives more complex for all parties. If you would like straight talk about your particular risk management situation, help navigating the challenges of derivatives regulation, or would just like to share your favorite Buffettism, please email us or give us a call. With clients like you – as the Oracle of Omaha often says – no wonder we tap-dance to work.