What is no surprise to anyone is that Warren Buffett is prescient. In his biography, "The Snowball" by Alice Schroeder, his warnings about the dangers of derivatives and debt swaps is more than a bit educational. It is spot on. In reading about his rescue of Salomon Brothers in the early 90's, that story could just as well be from yesterday's Wall Street Journal. Most chilling of all was the chapter set in the mid 90's, depicting the Long Term Capital Management (LTCM) melt-down. This debacle was the "perfect storm" revelation and powerful warning for Wall Street about the dangers of the labyrinth of leverage being weaved into a noose around the neck of the world's financial markets.John Meriwether, who had helped pilot Salomon's ship onto the reef only a few years earlier, took his hot-shot traders with him to form LTCM in Greenwich, Connecticut. They perched their 100 to 1 debt to equity ratio in the air like the battle flag of a gallant brigade. What it really was was a juggling act of apocalyptic proportions that almost created the same global catastrophe we face today. The players were all the same, the U. S. Treasury and the Federal Reserve Bank on one side; the Wall Street tycoons on the other. And although there was a private capital deal on the table led by AIG, Goldman Sachs and Berkshire Hathaway, for the sake of a smidgen more control by the principals, LTCM took the federal bailout. In fact, the discussions that took place in the halls of power were almost verbatim the ones that occurred during the past six months.
Warren Buffett has called for regulations of these cyber-cowboys for the last 15 years and refused to be involved in deals of this sort. It wasn't that he was totally fearful of exposure to risk. He had long been a force in re-insurance. It was rather the leverage represented by the debt swaps and derivatives and the fact that there was no way to quantify the risk. This securitized "caca" had been spread all over the world with unknown exposure to foreign banks and governments. At least in reinsurance, Buffett felt, he could use statistical probability to "handicap" the risk.
Today, we sit among the smoldering ruins of what Mr. Buffett warned of. The first crucial step must be to create a completely new regulatory scheme, with the input of the other G20 nations, that restores confidence in American leadership of the financial markets. China, who underwrites a large percentage of our Treasury debt, is already calling for this. If we fail to get this right, we can pump trillions of dollars down this black hole with nothing to show for it but British-style taxes for our children.
Once the confidence is restored, then and only then, the money will start to flow more easily and the credit crunch will abate. The neighborhood lender isn't going to lend until there is a way to quantify and qualify risk. Until then, sit back and watch the spiral continue.
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