Warren Buffett On The Financial Markets

The oracle of Omaha, in a recent Fortune Magazine article, comments:

Do you think the U.S. financial markets are losing their competitive edge? And what’s the right balance between confidence-inspiring standards and …

… between regulation and the Wild West? Well, I don’t think we’re losing our edge. I mean, there are costs to Sarbanes-Oxley, some of which are wasted. But they’re not huge relative to the $20 trillion in total market value. I think we’ve got fabulous capital markets in this country, and they get screwed up often enough to make them even more fabulous. I mean, you don’t want a capital market that functions perfectly if you’re in my business. People continue to do foolish things no matter what the regulation is, and they always will. There are significant limits to what regulation can accomplish. As a dramatic illustration, take two of the biggest accounting disasters in the past ten years: Freddie Mac and Fannie Mae. We’re talking billions and billions of dollars of misstatements at both places.

Now, these are two incredibly important institutions. I mean, they accounted for over 40% of the mortgage flow a few years back. Right now I think they’re up to 70%. They’re quasi-governmental in nature. So the government set up an organization called OFHEO. I’m not sure what all the letters stand for. [Note to Warren: They stand for Office of Federal Housing Enterprise Oversight.] But if you go to OFHEO’s website, you’ll find that its purpose was to just watch over these two companies. OFHEO had 200 employees. Their job was simply to look at two companies and say, “Are these guys behaving like they’re supposed to?” And of course what happened were two of the greatest accounting misstatements in history while these 200 people had their jobs. It’s incredible. I mean, two for two!

It’s very, very, very hard to regulate people. If I were appointed a new regulator – if you gave me 100 of the smartest people you can imagine to work for me, and every day I got the positions from the biggest institutions, all their derivative positions, all their stock positions and currency positions, I wouldn’t be able to tell you how they were doing. It’s very, very hard to regulate when you get into very complex instruments where you’ve got hundreds of counterparties. The counterparty behavior and risk was a big part of why the Treasury and the Fed felt that they had to move in over a weekend at Bear Stearns. And I think they were right to do it, incidentally. Nobody knew what would be unleashed when you had thousands of counterparties with, I read someplace, contracts with a $14 trillion notional value. Those people would have tried to unwind all those contracts if there had been a bankruptcy. What that would have done to the markets, what that would have done to other counterparties in turn – it gets very, very complicated. So regulating is an important part of the system. The efficacy of it is really tough.

Your OFHEO example implies you’re not too optimistic about regulation.

Finance has gotten so complex, with so much interdependency. I argued with Alan Greenspan some about this at [Washington Post chairman] Don Graham’s dinner. He would say that you’ve spread risk throughout the world by all these instruments, and now you didn’t have it all concentrated in your banks. But what you’ve done is you’ve interconnected the solvency of institutions to a degree that probably nobody anticipated. And it’s very hard to evaluate. If Bear Stearns had not had a derivatives book, my guess is the Fed wouldn’t have had to do what it did.

The interview can be found here.

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