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Janet Tavakoli’s Dear Mr. Buffett is an unusual amalgam of a simple, personal story and a complex, public one.

The personal story begins with an invitation from the Oracle himself:

“Be sure to stop by if you are ever in Omaha and want to talk credit derivatives...”

Buffett had just re-read Tavakoli’s Credit Derivatives & Synthetic Structures and noticed a letter from the author tucked between the book’s pages. With a quick apology and the above invitation, Buffett unknowingly set in motion a process that would give the public a rare glimpse inside his inner sanctum.

Tavakoli took Buffett up on his offer and recorded the ensuing encounter in Chapter 2 of Dear Mr. Buffett.

The promise of this tantalizing morsel will draw buyers in. But readers will find much more than another book on Warren Buffett.

The real story begins in 1998. That’s when Buffett’s Berkshire Hathaway bought General Re. Berkshire was a major insurer with a home-grown reinsurance business. General Re was considered the crème de la crème of reinsurers.

I say “considered”, because unbeknownst to Buffett there was a lot of crap among the crème. That crap came in the form of derivatives.

Meta-Bets

Derivatives are exactly what they sound like. The value of a plain vanilla security like a stock or bond is derived from the underlying business – its assets, earnings, and capacity to meet obligations. These are simple, straight bets.

Derivatives are meta-bets. Like an ironic narrator, they stand a level above the action. Instead of betting on a business, they bet on the betting on that business. Instead of betting on a borrower’s future income and collateral they bet on the bet a banker made on that borrower’s future income and collateral.

If the investment banks that created these derivatives used the same ad agency as BASF, their slogan would be: “We don’t make a lot of the securities you buy; we make a lot of the securities you buy riskier”.

Theory of Everything

Tavakoli has her own Theory of Everything in Finance:

“The value of any financial transaction is based on the timing of cash flows, the frequency of cash flows, the magnitude of cash flows, and the probability of receipt of those cash flows.”

It’s a simple theory. Derivatives are complex. But no amount of complexity can free a security from this iron clad rule.

“In finance, we make up a lot of fancy and difficult to pronounce names and create complicated models to erect a barrier to entry that keeps out lay people. High barriers tend to protect high pay. I’ve written about some of these esoteric products: credit derivatives, CDOs, and more, but before I look at the latest hot label dreamt up, I look at the cash to find out what is really going on.”

So does Warren Buffett.

Buffett Bets

As Tavakoli points out, financial journalists seized on Buffett’s description of derivatives as “financial weapons of mass destruction” while completely ignoring another passage in his 2002 letter to shareholders:

“Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.”

Although Buffett was concerned with the macro-risk presented by derivatives – especially the risk of a collateral requirement death spiral – he was still open to engaging in large-scale derivative transactions when it made sense for Berkshire.

Buffett takes risk from Wall Street firms willing to pay Berkshire well. For instance, Berkshire has assumed the risks of owning certain junk bonds.

But he sets the ground rules:

“He chooses the specific corporate names; he refuses ‘diversified’ portfolios containing a large number of corporations. He does trades in massive size – $100 million or more, if possible.”

Buffett applies the same principles he uses in common stock investing. He likes to be greedy when others are fearful and fearful when others are greedy. He likes opportunities where there is a perception gap – an inappropriate quantitative relationship between price and value that arises from some qualitative bias. And he likes to focus on what he knows. When he bets, he bets big. When he’s unwilling to bet big, he doesn’t bet.

Margin of Safety

Buffett is occasionally willing to assume first-to-default risk on a basket of junk bonds:

“Normally, first to default trades are viewed as the riskiest trades, and junk debt is viewed as the riskiest kind of asset; but Warren builds in a margin of safety that makes this a wise investment as long as Wall Street misprices the risk.”

Market participants who focus entirely on conventional indicators of quality – like triple-A ratings – miss opportunities to get great returns in “bad” assets and open themselves up to the danger of buying supposedly “good” assets at prices that provide no margin of safety – and when levered – provide a real risk of catastrophic loss.

Remember, Buffett bought into Moody’s common stock. He didn’t buy into their ratings system.

With lots of leverage and little value relative to price, you can go broke betting on good assets. Conversely, with little leverage and lots of value relative to price, you can get good returns from bad assets.

Buffett knows that. And he preaches what he practices:

“Investing in junk bonds and investing in stocks are alike in certain ways: Both activities require us to make a price-value calculation and also to scan hundreds of securities to find the very few that have attractive reward/risk ratios. But there are important differences between the two disciplines...Purchasing junk bonds, we are dealing with enterprises that are far more marginal. These businesses are usually overloaded with debt and often operate in industries characterized by low returns on capital. Additionally, the quality of management is sometimes questionable. Management may even have interests that are directly counter to those of debtholders. Therefore, we expect that we will have occasional large losses in junk issues.”

(2002 Letter to Shareholders)

A man famous for stressing the importance of buying into good businesses with high returns on capital run by able and honest management is willing to buy junk bonds of bad businesses with low returns on capital run by incompetent and “questionable” management – when the price is right.

Buffett is always focused on the relationship between price and value.

Tavakoli’s book chronicles the words and deeds of people who dealt in derivatives without knowing – and often without caring – what that relationship was.

Some will call her book a morality tale. I call it a rationality tale.

Source: On Buffett and Derivatives: A Review of Janet Tavakoli’s 'Dear Mr. Buffett'