Sunday, February 27, 2011

Charlie Munger on accounting and derivatives

I stumbled on a Spring 2009 interview in the Stanford Law Review with Charlie Munger, known better to some of you as Warren Buffet's partner at Berkshire, Hathaway.  Although it is almost 2 years old now, his comments are still absolutely relevant, especially since nothing really has been done to alter the landscape.  I urge readers to digest the whole interview, partly because he talks about issues we have not addressed.

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Young girl entertaining Mickey Mouse and other friends at a make-believe tea party, 1930s
In a simpler providence, a young girl entertains friends at a make-believe tea party, 1930s by State Library of Queensland, Australia, on Flickr

Mr. Munger is more straightforward in his speech patterns than Mr. Buffet. I find him refreshing even if I do not always agree with his point of view.

He rips the accounting profession pretty much throughout the whole interview:
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.
Can we fix the accounting profession?

Accounting is a big subject and there are huge forces in play.  The entire momentum of existing thinking and existing custom is in a direction that allows these terrible follies to happen, and the terrible follies have terrible consequences.  The economic crisis that we're in now, in its triggering circumstances, worse than anything that's ever happened.
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.
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.
So in order to cure the lame leg, you would lean more toward an approach to economics that takes human nature into account?
If you totally divorce economics from psychology, you’ve gone a long way toward divorcing it from reality.
The same could be said of psychology. If you divorce economics
from psychology …
That’s what’s wrong with psychology professors. There are so few of them that know anything about anything else. They have this terribly important discipline that all the other disciplines need and they can’t communicate that need to their fellow professors because they know so little about what these other professors know. This is not an unfair description of much of academia.
You and your partner, Warren Buffett, have for years warned about the dangers of the modern derivatives markets, particularly credit derivatives, and about interest rate swaps, currency swaps, and equity swaps.

Interest rate swaps have enormous dangers given their size and the accounting that has been allowed. But credit default derivatives took that danger to new levels of excess - from something that was already gross and wrong...
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 talks more about derivatives, as well as government regulation and banking structure. Read the whole interview.

Back in September, 2010, I wrote three articles talking about the very topic in this interview. I began with Personal Business: Financial regulation, Basel and free markets, summarized alternative suggestions for 'fixing' the banking system in Personal Business: Bank reform: the debate is the message, and proposed that fundamental changes had to be made, beginning with the accounting profession, Personal Business: Bank Reform: Simplify

That the professional institutions that we entrusted to nurture and guard our free markets have utterly failed, and that those highly paid professions need an overhaul is a constant and enduring theme on this blog. I wrote about it in The unfortunate issue with Mitt Romney, which also mirrors Munger's sentiments.

I challenge all professional colleagues to stand up for markets. Part of your job as a professional, as a critical member of society with specialized knowledge, is to guard the precepts upon which innovation and prosperity rely. If the Great Recession can not inspire you to do so, then look in the mirror and ask yourself exactly what events in your life need to occur before you are.

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