Those who invest only when commentators are
upbeat end up paying a heavy price for meaningless reassurance.
In my view a board of directors of a huge financial institution is derelict if it does not insist that its
CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other
employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees –
the financial consequences for him and his board should be severe.
It has not been shareholders who have botched the operations of some of our country’s largest financial
institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most
cases of failure. Collectively, they have lost more than $500 billion in just the four largest financial fiascos of the
last two years. To say these owners have been “bailed-out” is to make a mockery of the term.
The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may
have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these
CEOs and directors that needs to be changed: If their institutions and the country are harmed by their
recklessness, they should pay a heavy price – one not reimbursable by the companies they’ve damaged nor by
insurance. CEOs and, in many cases, directors have long benefitted from oversized financial carrots; some
meaningful sticks now need to be part of their employment picture as well.
There’s also a nice story about paying acquisition prices with undervalued or overvalued stock.
On having excess liquidity to survive through crises:
We never want to count on the kindness of strangers in order to meet tomorrow’s obligations
On General RE winding down its derivatives business:
Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I
got to know you so well.”
On derivatives’ markets:
Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal
disease: It’s not just whom you sleep with, but also whom they are sleeping with.
On investment philosophy:
Beware the investment activity that produces applause; the great moves are usually greeted by yawns.
On borrowing costs and government intervention:
Though Berkshire’s credit rating is pristine — we are one of only seven AAA corporations in the country — our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment it is far better to be a financial cripple with a government guarantee than a Gibraltar without one.
Dissertation on Black-Scholes formula over longer periods of time:
The Black-Scholes formula has approached the status of holy writ in finance, and we use it when
valuing our equity put options for financial statement purposes. Key inputs to the calculation include a contract’s
maturity and strike price, as well as the analyst’s expectations for volatility, interest rates and dividends.
If the formula is applied to extended time periods, however, it can produce absurd results. In fairness,
Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring
whatever caveats the two men attached when they first unveiled the formula.
It’s often useful in testing a theory to push it to extremes. So let’s postulate that we sell a 100- year $1
billion put option on the S&P 500 at a strike price of 903 (the index’s level on 12/31/08). Using the implied
volatility assumption for long-dated contracts that we do, and combining that with appropriate interest and
dividend assumptions, we would find the “proper” Black-Scholes premium for this contract to be $2.5 million.
To judge the rationality of that premium, we need to assess whether the S&P will be valued a century
from now at less than today. Certainly the dollar will then be worth a small fraction of its present value (at only
2% inflation it will be worth roughly 14¢). So that will be a factor pushing the stated value of the index higher.
Far more important, however, is that one hundred years of retained earnings will hugely increase the value of
most of the companies in the index. In the 20th Century, the Dow-Jones Industrial Average increased by about
175-fold, mainly because of this retained-earnings factor.
Considering everything, I believe the probability of a decline in the index over a one-hundred-year
period to be far less than 1%. But let’s use that figure and also assume that the most likely decline – should one
occur – is 50%. Under these assumptions, the mathematical expectation of loss on our contract would be $5
million ($1 billion X 1% X 50%).
But if we had received our theoretical premium of $2.5 million up front, we would have only had to
invest it at 0.7% compounded annually to cover this loss expectancy. Everything earned above that would have
been profit. Would you like to borrow money for 100 years at a 0.7% rate?
Let’s look at my example from a worst-case standpoint. Remember that 99% of the time we would pay
nothing if my assumptions are correct. But even in the worst case among the remaining 1% of possibilities – that
is, one assuming a total loss of $1 billion – our borrowing cost would come to only 6.2%. Clearly, either my
assumptions are crazy or the formula is inappropriate.
The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion
of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around
in some past period of days, months or years. This metric is simply irrelevant in estimating the probabilityweighted
range of values of American business 100 years from now. (Imagine, if you will, getting a quote every
day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing
quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm
a century from now.)
Though historical volatility is a useful – but far from foolproof – concept in valuing short-term options,
its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the Black-
Scholes formula now place on our long-term put options overstate our liability, though the overstatement will
diminish as the contracts approach maturity.
Even so, we will continue to use Black-Scholes when we are estimating our financial-statement
liability for long-term equity puts. The formula represents conventional wisdom and any substitute that I might
offer would engender extreme skepticism. That would be perfectly understandable: CEOs who have concocted
their own valuations for esoteric financial instruments have seldom erred on the side of conservatism. That club
of optimists is one that Charlie and I have no desire to join.
