• Choose a category
• All
• Classic-Fiction

As lending standards declined, the hedge funds investing in CDOs took on more leverage, as much as $100 in debt per dollar of capital, and the quality of the CDOs—even AAA CDOs—got sludgier. Some investors did get nervous about the more obviously phony aspect of the way the market was operating and wanted to hedge their bets.6 They tapped into a market that had developed to bet on whether loan defaults would occur: the credit default swap. If a securitization lost value because loans defaulted, the issuer of the swap would have to pay.

Protected by credit default swaps, investing in CDOs now appeared to contain no risk. “When money is free,” wrote Charles Morris later, “and lending is costless and riskless, the rational lender will keep on lending until there is no one left to lend to.”7

If it was pointed out that risk did not disappear, those who participated in the market would explain with a sigh that securitization and swap derivatives “spread” the risk to the far corners of the globe, where it would be absorbed by so many people that it could never hurt anyone.

Thus freed, the rational people of the mobile-home business had lowered down payments, making it much easier to get loans. As the real-estate market boomed, riskier types of home loans—along with commercial and business and student and other loans—spread like a cold virus in a kindergarten. These, like the mobile-home loans, were stripped, insured, “securitized,” and speculated on over and over through credit default swaps. Meanwhile, other, more exotic derivatives proliferated.

In his 2002 shareholder letter, Buffett called derivatives “toxic,” and said they were “time bombs” that were expanding unchecked and could cause a chain reaction of financial disaster. At the shareholder meeting that year, Charlie Munger described the accounting incentives to exaggerate profits on derivatives, and concluded, “To say derivative accounting in America is a sewer is an insult to sewage.” In his 2003 letter, Buffett wrote of derivatives as “financial weapons of mass destruction.”8 So many of these deals existed, he wrote, that they had formed a daisy chain around the globe. Despite the advice of their mathematical models to buy rather than sell into a crisis, when trouble approached, investors fled their watering hole like a herd of giraffes escaping a lion. And while many people appeared to be participating in a market, in fact a handful of large financial institutions would always tend to dominate it using their leverage. They would also have other assets that seemed uncorrelated with these derivatives but which would actually move in tandem with the derivatives in a collapsing market.

General Re had a derivatives dealer, General Re Securities, which Buffett had shut down, either selling its positions or letting them run off in 2002. He had already turned Gen Re Securities into the cautionary tale of derivatives—writing at length to the shareholders about the expensive and problematic cost of shutting it down. General Re had made Buffett so angry by losing almost $8 billion by now from insurance underwriting that he could barely talk about it. The Scarlet Letter remained posted on the Berkshire Web site, though Ron Ferguson had retired, replaced by Joe Brandon and his number two, Tad Montross. General Re’s competitors gleefully told clients that Buffett was going to sell the company or shut it down. Given the example of Salomon, these predictions were not spun from gossamer. Buffett had taken away part of General Re’s new business after 9/11 and given it to Ajit Jain’s Berkshire Re, rather than infuse more capital into General Re to shore up its balance sheet.9 He had also started funding competitors of General Re through Jain and through Lloyd’s of London. He rationalized this in various ways; he himself may not have recognized a classic pattern—when anxious, Buffett always sought escape hatches and trapdoors. He was not “punishing” General Re; rather, Buffett was instinctively hedging the risk that General Re