Charlie Munger, Warren Buffett's right hand, and Vice-Chairman of Berkshire Hathaway, was recently interviewed by Joseph Grundfest, in Stanford Lawyer magazine. It's a substantial interview, in which Munger offers his profound and eloquent views. Here are a few excerpts:
On the accounting profession:
JG: As we look at the current situation, how much of the responsibility would you lay at the feet of the accounting profession?
CM: 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.
JG: Would you give an example of a particular accounting practice you find problematic?
CM: 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.
JG: And they can't both be right. But both of them are following the rules.
CM: 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.
About the chances of a Great Depression?
JG: And do you see a chance that our current economic woes could reach to a level closer to the Great Depression?
CM: Well, nobody can predict that very well because we've never faced conditions as extreme. 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.
When the regulators put in the option exchanges, there was just one letter in opposition saying "you shouldn't do this," and Warren Buffett wrote it. When they wanted to make the securities market function better as a gambling casino with vast profits for the people who were croupiers-there was a big constituency in favor of dumb change. Buffett was like a man trying to stop an elephant with a pea shooter. We're not controlling financial leverage if we have option exchanges. So these changes repealed longtime control of margin credit by the Federal Reserve System.
On modern derivatives markets
JG: 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.
CM: 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. In the '20s we had the "bucket shop." The term bucket shop was a term of derision, because it described a gambling parlor. The bucket shop didn't buy any securities. It just enabled people to make bets against the house and the house furnished little statements of how the bets came out. It was like the off-track betting system.
JG: Until the house lost its money and suddenly disappeared. Or the house made its money and suddenly disappeared.
CM: That is right. Derivatives trading, with no central clearing, brought back the bucket shop, because you could make bets without having any interest in the basic security, and people did
make such bets in the billions and billions of dollars. Some of the most admired people in finance-including Alan Greenspan - argued that derivatives trading, substituting for the old bucket shop, was a great contribution to modern economic civilization. There's another word for this: bonkers. It is not a credit to academic economics that Greenspan's view was so common.
Read the complete interview here.
