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  • The Berkshire Bailout: Congress Misunderstands Markets

    The Wall Street Journal reports that Barack Obama’s favorite capitalist, Warren Buffet, is seeking an exemption from Obama-endorsed derivatives rules for his insurance-and-everything conglomerate, Berkshire Hathaway.

    Derivatives are risk-shifting financial contracts that Buffet infamously described as “weapons of financial mass destruction.”   After the 2008 financial crisis, Buffet decided to join the nuclear club and Berkshire has amassed a $63 billion derivatives portfolio.

    At issue is a proposed new rule in the Senate financial reform legislation requiring everyone who buys, sells, or trades derivatives to post collateral: cash or cash equivalents to protect against losses on the contract.  Buffet doesn’t want the new rules to apply retroactively to contracts his company has already written.

    Buffet has a fair point on retroactivity: Congress should not rewrite contracts already in force.  But the retroactivity argument obscures a larger point: why should anyone be required to post margin on a derivatives trade?

    Traditional regulatory principles require financial intermediaries such as banks and brokers to retain capital or post margin to protect against losses and to ensure the institution can meet it obligations.  Capital rules are applied to financial intermediaries because their failure would affect other customers and the economy more generally.

    Ordinarily, however, government capital rules don’t apply to customers of banks and brokers (there are very limited and specific exceptions).  Banks and brokers often impose down payment, margin, collateral, surety or similar requirements on their customers, but that is a judgment for the bank, not for the government.  The government looks at a bank’s entire portfolio and sets capital requirements high enough to protect the bank, not to protect every individual loan.

    Because the government chose to bail-out insurance giant AIG following losses on derivatives contracts, Congress has decided that customers who buy and sell derivatives, not just the banks that trade them, have to post collateral.  But even if there is a case that very big players – such as AIG or Berkshire – represent “systemic risks,” justifying a capital requirement, the Senate bill is a massive over-reaction, requiring every buyer and every seller to post collateral for every trade.

    Perversely, the burden of collateral requirements won’t be felt most harshly by the big boys (Berkshire has plenty of cash), but by small users who represent no systemic risk whatsoever.  The result will be that derivatives are more expensive, and used less often to mitigate risk.

    There are refined tools that Congress and regulators can use to promote stability in derivatives markets.  The problem with the Senate derivatives bill is that Congress doesn’t understand markets, so it tries to regulate everything.  It is not Warren Buffet who will be hurt most, retroactivity or not, but marginal businesses that will no longer have affordable ways to mitigate financial risks.

    Posted in Economics [slideshow_deploy]

    10 Responses to The Berkshire Bailout: Congress Misunderstands Markets

    1. Mike, TX says:

      We're putting too fine a point on this distinction, Dave. Banks and brokers are merely passing through the margin requirements to their customers so that the banks and brokers do not have to fund the obligations of their clients themselves. In the over-the-counter market, the absence of a clearinghouse/market-maker makes it impossible to create a parallel regulatory framework. At the end of the day, these are common-sense rules to prevent big institutions from making too many contingent payment promises (which may be relatively small bets in of themselves) from coagulating into a serious problem of "systemic size".

      At issue here is that Berkshire may have entered into too many of these transactions and is not currently sensibly collateralized. We may have stumbled onto someone who is not wearing any shorts now that the tide is out, to borrow a phrase.

    2. stirling, Pennsylvan says:

      "Warren Buffet, is seeking an exemption from Obama-endorsed derivatives rules for his insurance-and-everything conglomerate, Berkshire Hathaway." I'm sure the "Big Guys" would oppose this administration in spades if they were actually going to be hurt by the legleslation. Unfortunately government will kiss up to them to passify them enough to alow it to pass. Comon people get a backbone and see what the bill is a power grab by government to take over the financial system (which will hurt rather then help in the long run.)

    3. Ron St. Petersburg says:

      So this is what Warren Buffet means by going around claiming "people like him" should have higher taxes. "People like him" yes, just not him. What a fake he is!

    4. Billie says:

      What an insult these people are, in the positions they are. What an embarrassment to the people of this country. How indecent! How outrageous!

      What failed disgraces they have become under the new leader!!!!! But under the new leader that makes these failures, SUCCESS!

    5. James A says:

      Thanks for the comments. Humor and insight: priceless. Especially Mike TX.

    6. Rod Davidson, Camano says:

      If the derivatives market becomes too heavily regulated by US lawmakers, thousands of brokers will be reassigned (or new ones hired) to Hong Kong, Singapore, Macau, London, etc. The high paying jobs will leave NY, and guess who will pay the ultimate price? The citizens of NY City, who will lose critical tax dollars to provide services such as law enforcement, teachers and firemen.

      Other aspects of the financial reform will result in less credit being made available, higher interest rates on credit and the transfer of fees levied on the banking system to the general public.

    7. Ross writes from Flo says:

      Whatever the federal government regulates or "runs" a business, it goes broke. Just look at the Mustang Ranch bailout when the business went bankrupt a few years ago. They couldn't even make the famous whorehouse profitable. What else can be said, (maybe they should have let the NY SEC office run it. They seem to understand that business as customers).

    8. Drew Page, IL says:

      Wait a second, isn't this the same Warren Buffet who said, not too long ago, that people like him should be paying more in taxes? So why then is he looking for an exemption? Salute the flag and pay up Warren, it's not like you can't afford it.

      I guess derivitives, those risk shifting contracts that are financial weapons of mass destruction are only bad if you don't get to sell them.

      What a fraud, no wonder he's in Obama's camp.

    9. Spiritof76, NH says:

      Warren Buffet is OK with a fascist America just like Obama. People like Warren who complain about low taxation for him and other of his rich friends can easily correct that problem without having to punsih everyone else by simply writing a check to the Treasury. Warren, believe me, the IRS will accept the check.

    10. pat blood says:

      These people almost brought the world markets to crash——Buffet needs to pay up. Too bad Nelson was for sale.

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