Berkshire’s Munger Favors ‘100% Ban’ on Credit Swaps (Update

[Ognir]

By Betty Liu, Shannon D. Harrington and Erik Holm

May 1 (Bloomberg) -- Berkshire Hathaway Inc. Vice Chairman Charles Munger said he supports an outright ban of credit- default swaps to prevent speculators from profiting on the failure of companies.

"If I were the governor of the world, I would eliminate it entirely -- 100 percent," Munger said in a Bloomberg Television interview today. "That's the best solution. It isn't as though the economic world didn't function quite well without it, and it isn't as though what has happened has been so wonderfully desirable that we should logically want more of it."

Munger, second in command at Omaha, Nebraska-based Berkshire behind billionaire Chairman Warren Buffett, has long decried some of Wall Street's tactics as short-sighted. He said in a Washington Post opinion column in February that the U.S. government must expand regulation to prevent the excesses that caused the current fiscal crisis, and said credit-default swaps were partly to blame.

Munger, 85, and Buffett have touted a buy-and-hold strategy of investing in undervalued firms as a more reliable way to profit from financial markets. The two have at times departed from that approach, and Berkshire began selling credit-default swaps on individual companies in 2008. The firm backed $4 billion in debt of 42 corporations as of Dec. 31, Buffett, 78, said in a February letter to shareholders.

'Stupid Policy'

"The national policy that allowed the derivative markets to develop as they did was a stupid policy and we think the derivative markets as they evolved have done more public damage than public benefit," Munger said. "That said, if they exist and they are legal and some opportunity therein is presented to us that we think makes sense to the shareholders of Berkshire, we would seize that opportunity."

Berkshire is scheduled to hold its annual shareholder meeting tomorrow.

Credit-default swaps "play an important role in the growth and function of our nation's and the global economy," Robert Pickel, chief executive officer of the International Swaps and Derivatives Association, said in a statement. ISDA, which sets rules for the market, published a survey of the world's 500 largest companies last month that found 76 percent of financial firms and 20 percent of all companies used credit swaps.

"Amidst the current financial turmoil, the CDS market has performed well, remained liquid and is providing an important price signaling function," Pickel said.

'Grease the Skids'

The proliferation of credit-default swaps in the portfolios of debt investors and banks can eliminate incentives lenders have to keep companies out of bankruptcy, according to academics including Henry Hu, a law professor at the University of Texas in Austin, who testified before Congress in October on the so- called debt decoupling created by derivatives.

Creditors that have hedged themselves "might well want its borrower to go into bankruptcy and have incentives to use its control rights to help grease the skids," Hu told the House Committee on Agriculture, which oversees the Commodity Futures Trading Commission.

Credit-default swaps, which are used to hedge against losses or to speculate on a company's ability to repay its debt, pay the buyer face value if a borrower defaults in exchange for the underlying securities or the cash equivalent.

"The whole mass of incentives created is quite counterproductive," Munger said. Buyers of the swaps get a "vested interest in the destruction of some business."

High Yield, High Risk

Berkshire also used credit derivatives to bet on indexes of 100 companies with high-yield, high-risk debt, and the company paid losses of $542 million on premium revenue of $3.4 billion, Buffett wrote in February. The contracts caused an accounting liability of $3 billion as of Dec. 31, Buffett said.

"In last year's letter, I told you I expected these contracts to show a profit at expiration," Buffett said. "Now, with the recession deepening at a rapid rate, the possibility of an eventual loss has increased."

Credit swaps guaranteeing mortgage-linked debt led to the near failure of Berkshire competitor American International Group Inc. last year when the insurer was unable to post collateral as the assets plunged. AIG has received four U.S. bailouts valued at $182.5 billion.

Collateral Damage

Buffett said his firm is unlikely expand the sale of swaps tied to individual companies because would-be counterparties demand collateral if the underlying assets decline "and we will not enter into such an arrangement."

At least 32 companies as of March 12 had more credit swap protection outstanding on their bonds than actual bonds, according to a March 27 research note by Christopher Garman, chief executive officer of Garman Research LLC in Orinda, California.

"Simply put, there may be less forbearance in store for stressed companies where credit-default swaps notional greatly outstrips the deliverable bond," he wrote. "Hedges may have entirely taken out the default risk."

Credit-default swaps dealers, including JPMorgan Chase & Co., Deutsche Bank AG and Barclays Plc, have taken steps at the behest of regulators to improve transparency in the market, where there were at least $27.5 trillion in contracts outstanding as of April 24, according to the Depository Trust & Clearing Corp., which runs a central registry that captures most trades.

$2.5 Trillion

After subtracting trades that offset each other, banks, hedge funds and other asset managers have bought protection on a net $2.5 trillion in debt using the privately negotiated contracts.

Dealers and investors last month created a committee to govern key decisions for the market, such as when the contracts can be settled and what securities are covered by the derivatives. The committee for the first time brought into the decision-making process investors that weren't among Wall Street dealers.

House Agriculture Committee Chairman Collin Peterson in January circulated a draft bill that would have banned credit swaps trading unless investors owned the underlying bonds. The bill that passed the Minnesota Democrat's committee the following month stopped short of an outright ban, though it would allow the CFTC to suspend trading in the market, if needed, to protect investors. The bill has not been taken up by the full House of Representatives.

U.S. Treasury Secretary Timothy Geithner, who in his past post as president of the Federal Reserve Bank of New York pushed dealers to curb the potential for systemic risks from the market, told Congress in March that a ban such as Peterson had proposed "is not necessary and wouldn't help fundamentally."

To contact the reporters on this story: Betty Liu in Omaha at sharrington6@bloomberg.net; Erik Holm in Omaha at mailto:eholm2@bloomberg.net">eholm2@bloomberg.net
Last Updated: May 1, 2009 18:35 EDT