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Wednesday, March 23, 2011

Buffett, derivatives, and smoothing earnings

"Perhaps the most insightful nugget in [Warren Buffett's recent testimony to the Financial Crisis Inquiry Commission]," wrote Andrew Ross Sorkin in the New York Times on March 15, "was Mr. Buffett's explanation of why corporations use derivatives--and why they probably shouldn't."  They do it to hedge currency or price risks that can affect their business (examples include Coca-Cola and Burlington Northern)--no surprise there.  Or corporations use derivates to smooth earnings.  This other "agenda" seems to surprise Sorkin, and Buffett evidently frowns upon it.

What's missing from this picture is quasi-government policy, that of the Financial Standards Accounting Board.  As I wrote here in May 2009:

In the nineteenth and early twentieth centuries, many public companies regarded it as prudent to set aside a portion of their earnings as reserves against a rainy day.  The idea was that the reserves would enable them to continue paying dividends – and thereby safeguard the market value of their shares – in years when their current earnings were inadequate. 
In 1975, this practice was ruled unacceptable by the Financial Accounting Standards Board.  Its FAS Statement No. 5 required reserves to be accrued for losses that were “probable” and could be estimated; it explicitly prohibited “reserves for general contingencies” (§14).    The board was fully aware of the arguments in favor of a general reserve fund.  In its words, “The Board recognizes that some investors may have a preference for investments in enterprises having a stable pattern of earnings, because that indicates lesser certainty or risk than fluctuating earnings.  That preference, in turn, is perceived by many as having a favorable effect on the market prices of those enterprises’ securities” (§65).  But the alternative to setting aside reserves – purchasing insurance or reinsurance – was preferable, the Board concluded, and it overruled prudence:  “Earnings fluctuations are inherent in risk retention, and they should be reported as they occur” (§65). 
FAS Statement No. 5 thus tied public firms more closely to the ups and downs of the market (and surely stimulated the insurance/derivatives market as well), with pro-cyclical consequences, as others have noted.[2]
So it's not at all surprising that corporations use derivatives to smooth earnings--what other choice do they have?  Now if the Bretton Woods regime of fixed-exchange rates hadn't broken down in 1971, and Chicago institutions hadn't responded by extending the concept of commodity futures to currency in 1972 and then well beyond currencies, they really would have no choice but to let earnings fluctuate in real time.

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