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Thursday, April 29, 2010

Financial "Reform" and Berkshire Hathaway

Warren Buffet was criticizing one aspect of the proposed financial "reform" law. Certain insurance and derivative contracts will be subject to higher capital requirements.

The problem is that the current version of the regulation also affects previously existing contracts. In effect, Congress is altering private contracts.

Suppose A and B agree to a derivative contract. They also agree to a 1% margin requirement. Congress passes a law imposing a 10% margin requirement. Congress altered this private contract. The problem is that the trade was profitable with 1% margin. With 10% margin required, the trade becomes a big money-loser.

Berkshire Hathaway makes many reinsurance contracts. They might be subject to a higher margin requirement. Also, the proposed law requires cash collateral, while Berkshire Hathaway currently invests the collateral. The proposed law would wreck Berkshire Hathaway's future business. The proposed law would make many current reinsurance contracts unprofitable.

There's a problem with reinsurance and certain derivatives like credit default swap insurance. There is only a small chance of a payout, but the loss is huge when a payout does occur. The proposed law would cause the price of reinsurance to skyrocket.

With high margin requirements, the price of reinsurance would be much higher. With low margin requirements, there's a risk of default when a payout is needed; that's what happened to AIG. In effect, Berkshire Hathaway's business will be ruined due to mistakes made at AIG.

One solution is to grandfather old contracts. However, that would lead to a bunch of contracts getting signed just before the law passes. Besides, what right does Congress have to impose restrictions on private contracts?

However, banks and Berkshire Hathaway receive massive direct and indirect State subsidies. Even though Warren Buffet criticizes State largesse, I've never heard him say "The Federal Reserve central bank credit monopoly is immoral!" Even though Berkshire Hathaway doesn't borrow from the Federal Reserve, State monetary policy affects Berkshire Hathaway's access to capital at cheap rates.

One amusing bit was Warren Buffet saying "WTF? Congress can't alter private contracts! That's a dangerous precedent." That's exactly what happened in 1933, when President Roosevelt defaulted on the gold-redeemability of the Federal Reserve Note, confiscated the gold, and devalued the dollar.

In 1933, Congress also declared "gold clauses" illegal, a decision upheld by the Supreme Court. Anticipating a gold standard default, clever lenders inserted "gold clauses" into their debt contracts. If the dollar were devalued relative to gold, then the principal and interest due would increase proportionally. By declaring these gold clauses invalid, Congress stole from every creditor. Congress breached every private debt contract. Insiders knew this law was coming and borrowed as much as they could, repaying with devalued dollars.

In 1975, gold ownership was re-legalized. I don't know if the legal system would enforce a gold clause in a post-1975 contract. I tried looking it up and got conflicting answers from different sources. I don't know of anyone using a gold clause. For example, suppose a celebrity signs a 5 year contract to do a show. To protect himself from inflation, the celebrity really should ask for a gold clause. I don't know of anyone who has asked for a gold clause, so I don't know if the legal system would enforce such a contract.

For example, A-Rod gets paid $25M per year for 10 years; the fallacy is that $25M ten years from now is worth a lot less than $25M when the contract was signed. To be really fair, A-Rod should have asked for a gold clause. Then, he's protected from the devaluation of the dollar.

In the present, the banksters don't mind inflation, because they borrow at the Fed Funds Rate and lend money. Their profit rate is unrelated to inflation. Their profit rate is the interest rate spread times their leverage ratio. Therefore, the banksters load up on as much leverage as they can. The banksters like inflation. Inflation makes it more likely that borrowers can repay their loan. Banksters profit from printing and spending/lending brand new money.

There actually was a precedent before 1933, of Congress breaching private debt contracts. President Lincoln's greenbacks were accompanied by a legal tender law. Even so, greenbacks traded at a discount to gold. Someone borrowed dollars/gold and made payment with greenbacks. The creditor refused to accept them, because they were worth much less than gold. The Supreme Court ruled that the creditor had to accept the greenbacks, even though the debt contract specified payment in gold.

The proposed financial industry "reform" law is one big evil fnord. The real problem is the Federal Reserve credit monopoly, combined with laws and taxes that forbid use of sound money. The "reform" law completely ignores the real problem. It probably was written by lobbyists for the financial industry.

Warren Buffet's criticism shows the problem with any new regulation. Higher capital requirements sounds like a good idea. However, that could also cause prices to skyrocket. The only way to find the fair requirement is via a really free market.

In a really free market, an insurer/bank with too much leverage would be subject to a run and lose customers. An insurer/bank with too little leverage is charging too much. Even before 1913, State regulations required banks to operate under corrupt fractional reserve principles. In the present, the banksters have a State-backed monopoly.

Many investment banks, like Goldman Sachs, primarily borrow from the State/Federal Reserve. They don't need to have any customers/depositors!

The US financial system is one big scam. The proposed financial "reform" law is an evil fnord designed to preserve the scam, while providing the illusion of reform.

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