"Munger on Phony Accounting, Cultural Decay, and Derivatives
Stanford Law Review has a great interview with Warren Buffett's longstanding partner, Charlie Munger. Munger offers much less corn pone and more direct opinion than Buffett does.
The entire piece is very much worth reading, but I wanted to hone in on some key topics. One is the neglect of the role of what amounts to accounting fraud in this mess. Much of this is technically not fraud under the current regime but would be if the standards of 20 years ago were still in place. We now live in a world where everyone knows that the authorities simply will not take down any of the Big Four. Four is now deemed to be the minimum number of big accounting firms permissible. So we de facto have accounting firms "too big to fail", which means "too big to be asked to eat much liability, not matter how indefensible their conduct." So if they do something bad, they might have to fire a few partners and pay a moderate fine.
So effectively, we live in a world that echoes the Nixon Presidency. If the Big Four does it, it must be legal.
From the Stanford Law Review (hat tip reader Hubert):
As we look at the current situation, how much of the responsibility would you lay at the feet of the accounting profession?
I would argue that a majority of the horrors we face would not have happened if the accounting profession developed and enforced better accounting. They are way too liberal in providing the kind of accounting the financial promoters want. They've sold out, and they do not even realize that they've sold out.
Would you give an example of a particular accounting practice you find problematic?
Take derivative trading with mark-to-market accounting, which degenerates into mark-to-model. Two firms make a big derivative trade and the accountants on both sides show a large profit from the same trade.
And they can't both be right. But both of them are following the rules.
Yes, and nobody is even bothered by the folly. It violates the most elemental principles of common sense. And the reasons they do it are: (1) there's a demand for it from the financial promoters, (2) fixing the system is hard work, and (3) they are afraid that a sensible fix might create new responsibilities that cause new litigation risks for accountants....
Very few people realize how much we've screwed up. Even in leading law schools and business schools very few people realize that the mess at Enron never could have happened if accounting customs hadn't been changed. What we have now is a bigger, more widespread Enron.
Munger also has some interesting observations about the decay in values:
Worse than the Great Depression?
The economy hasn't contracted as much as during the Great Depression, but the malfeasance and silliness, the triggering events for today's crisis, were much greater and more widespread. In the '20s, a tiny class of people were financial promoters and a tiny class of people were buying securities. Today, it's deep in the whole culture, and it is way more extreme. If sin and folly get punished appropriately, we're in for a bad time....
The investment banks of yore, chastened by the '30s, were private partnerships, or near equivalents. The partners were dependent for their retirement on the prosperity of the firms they left behind and the customs and culture they left behind, and the places were much more responsible and honorable. That ethos, by the time the year 2006 came along, had pretty well disappeared. Our regulators allowed the proprietary trading departments at investment banks to become hedge funds in disguise, using the "repo" system—one of the most extreme credit-granting systems ever devised. The amount of leverage was utterly awesome. The investment banks, to protect themselves, controlled, to some extent, the use of credit by customers that were hedge funds. But the internal hedge funds, owned by the investment banks, were subject to no effective credit control at all.....
How and why do you think economists have gotten this so wrong?
I would argue that the economists have not been all that good at working concepts of good and evil into their profession. Nor do they understand, at all well, the economic consequences of bad accounting.
In fact, they've made a profession of driving value judgments out of the subject.
Yes. They say it's not economics if you think about the consequences of good and evil, and good and bad business accounting. I think what we're learning is that when you don't understand these consequences, you don't have an adequately skilled profession. You have big gaps in what you need. You have a profession that's like the man that Nietzsche ridiculed because he had a lame leg and was very proud of it. The economics profession has been proud of its lame leg.
There is also a good bit on why he and Warren have been so successful:
You've often said that one of the keys to your success has simply been to avoid making the garden-variety mistakes that you see other people make.
Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It's not a competency if you don't know the edge of it. And Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error.
If you had to characterize a few mistakes that you see executives making, which ones jump out at you?
An extreme optimism based on an inflated self-appraisal is one. I think that many CEOs get carried away into folly. They haven't studied the past models of disaster enough and they're not risk-averse enough. One of the very interesting things about Berkshire Hathaway is how chicken it is, how cautious, how low is its leverage.
I can't speak for Berkshire overall, but that is certainly true of their reinsurance business. Ajit Jain is willing to sit around and do no business, even if he has to wait a couple of years, until, say, two hurricanes hit in 72 hours and the industry is desperate for reinsurance capacity and willing to pay big premiums. They are very disciplined and play only in "hard markets". "
"They are very disciplined and play only in "hard markets"
Value investing is very hard, and the reason it is makes me doubt the efficacy of so-called "counter-cyclical" policies.
"the malfeasance and silliness, the triggering events for today's crisis, were much greater and more widespread"
I agree with this, but also believe that it goes against arguments such as Winkler's view that:
"Asset managers are more or less forced to seek higher interest rates through riskier investments."
No one is forced into malfeasance and silliness. They are embraced by human beings for their own reasons and desires.
Don the libertarian Democrat