The Snowball_ Warren Buffett and the Business of Life - Alice Schroeder [326]
Another example: Suppose that Warren made a deal with Astrid to give up eating potato chips for a year. If he ate a potato chip he had to pay her a thousand bucks. This would not be a derivative contract. Warren and Astrid were simply making a deal. Whether Warren ate a potato chip was not “derived from” anything. It was under his own control.
However, if Astrid and Warren made that agreement and then Astrid paid Warren’s sister Bertie a hundred bucks as insurance, in exchange for a thousand dollars if Astrid lost the bet, the deal with Bertie would be a derivative contract. It would be “derived from” whether Warren ate the potato chips, which was not under either Bertie’s or Astrid’s control. Astrid stood to lose the hundred bucks to Bertie if Warren didn’t eat the chips, and Bertie would lose a thousand bucks if he did. “Derivatives,” therefore, are either a type of insurance (for Astrid) or an outright gamble (for Bertie).7
Most people buying and selling derivative contracts do so based on an impersonal index, setting the contract without ever meeting their counterparty. The S&P “equity index futures” that money managers were buying as insurance in 1987 paid them back if the stock market fell below a certain level. People who assumed the market would keep going up were often “gambling” by “selling” the insurance. They wanted income from the premiums.
Buffett had written to Congress citing the risk inherent in these deals and urging regulation of this market as long ago as 1982, but nothing changed.8 Since then, equity index futures had swarmed like gnats in July. If stocks started to fall, all the bills would be presented to the sellers of insurance at once. They would have to dump stocks to meet their claims. The buyers of the index futures, meanwhile, were often using them to insure “program trades” that would sell automatically as the market fell, triggering a cascade of sales.
By the early fall the market got nervous, and began to stutter and stall. On Black Monday, October 19, 1987, stocks plunged a record-breaking 508 points as everybody tried to squeeze through the keyhole at once. The market came close to a trading halt, as it did in 1929, and suffered its largest one-day percentage drop in history.9
The Buffett Group happened to be meeting on the third day of the avalanche, this time in Colonial Williamsburg. Kay Graham had been put in charge of the arrangements, and she used Williamsburg’s atmospheric celebration of America at its purest, most patriotic moment to elevate the meeting from its formerly “slapdash, amateur effort by whoever,” as Buffett put it, to a whole new standard. The group was chauffeured everywhere, and members who were used to bran flakes at breakfast woke to find “enough food for a thousand people,” as one member described it, with chicken, steak, ham, and chicken livers served alongside their eggs. Graham hired Carter’s Grove Plantation, a historic eighteenth-century mansion fronting the James River, for a formal dinner one night and rented out a theater to screen a movie produced by Rick Guerin, some of whose money had been funneled directly into Hollywood. As the events crescendoed, each more elaborate than the last, the group was awestruck by the contrast with prior years, as well as by the expense. “How wonderful of Kay to have us as her guests,” Chuck Rickershauser said, as everybody in earshot nodded. On the final evening, Graham hired costumed chamber musicians to play Haydn during a private dinner at the DeWitt Wallace museum.10
The topic planned for discussion as stocks were peaking had been “Is the Group finished with the market?” Instead, with the market crashing around their ears, for three days Buffett, Tisch, Gottesman, Ruane, Munger, Weinberg, and the others glowed like fireflies as they flickered in and out of the room, checking stock prices and phoning their