Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street by Janet M. Tavakoli

Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street by Janet M. Tavakoli

Chapter 1
An Unanswered Invitation
Be sure to stop by if you are ever in Omaha and want to talk credit
derivatives . . .
—Warren Buffett in a letter
to Janet Tavakoli, June 6, 2005
It was August 1, 2005, and I was rereading a letter in my correspondence
file dated June 6, 2005.The letter was from Warren Buffett, the CEO of the
gargantuan Berkshire Hathaway conglomerate. I had not yet responded and
had no explanation for the delay save for a little awe. For the several years
prior, Fortune listed Warren Buffett as either the richest or second richest
man on the planet. He and Bill Gates annually jousted for the top spot, with
the outcome depending on the relative share prices of Berkshire Hathaway
and Microsoft.
Several years earlier, I had sent Warren Buffett a copy of my book, Credit
Derivatives & Synthetic Structures. In his letter Buffett wrote that he had
been looking at the book again and had just found a letter I had tucked
between the pages, “Please accept my apologies,” he continued, “for not
replying to you when I first received it.” He invited me to stop by if I were
ever in Omaha. I looked up. After all this time, I could not remember what I
had written in that old letter. I did know that I had not expected a response.
But certainly now a response was needed from me, a belated one.“Dear Mr.
Buffett,” I began.
I am an investor in Berkshire Hathaway “A” shares, but Mr. Buffett would
have no way of knowing that since I hold shares in brokerage accounts.
Perhaps Mr. Buffett had a bone to pick with me, but I had warned about the
risk of credit derivatives and the hidden leverage they created. I was so
persistent in exposing the flaws in the financial system that BusinessWeek
called me the “Cassandra of credit derivatives.” But most journalists
overlooked a much more important derivatives quote in Mr. Buffett’s 2002
shareholder letter. Berkshire Hathaway invests in multinational businesses
with a variety of complex operations, and that means that investments have
to be hedged or entered into in ways that create tax or accounting
advantages. Mr. Buffett had also written:“I sometimes engage in large-scale
derivatives transactions.” Yet I dithered and had not responded to his letter.
In 1998, Berkshire Hathaway acquired General Reinsurance. Warren
Buffett initially called it his “problem child,” and its General Reinsurance
(Gen Re) Securities unit was its problem sibling. Even before the
acquisition, both Warren Buffett and Berkshire Hathaway vice-chairman
Charlie Munger realized that the value of Gen Re Securities derivatives
transactions was overstated and vainly tried to sell it. Some of the contracts
were for 20-year maturities, and the operation would take years to wind
down. Furthermore, the models valuing the derivatives give poor
approximations of the true mark-to-market value—the price at which the
derivative can be bought and sold in the market—of some of Gen Re
Securities’ esoteric derivatives contracts. There was no real market. Instead,
the derivatives contracts were priced or marked based on model valuations
known as mark to model. Buffett wrote that in extreme cases, it was a
“mark to myth.”
In his 2002 letter to Berkshire Hathaway shareholders, Buffett wrote that
it sometimes seemed “madmen” imagined new derivatives contracts. His
pique was prompted by the multiyear-long hangover of losses from
derivatives, chiefly credit derivatives, in the GenRe Securities unit. It

Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street by Janet M. Tavakoli