Charlie Munger on Risk Management

At the 2022 Berkshire annual meeting - Munger's last before his death in November 2023 - he was characteristically blunt about what he refused to touch. He told the audience that he tried to avoid things that were evil, stupid, and made him look bad relative to someone else. The formulation compressed Munger's lifelong filter into a single line: a thing did not have to be all three to be avoided; any one of the three was sufficient. The investor who internalized the rule would refuse most of the propositions the market pressed on him. He sharpened the point with reference to crypto. Munger had been a public critic of cryptocurrency for years, and at the 2022 meeting he did not soften. He told the audience that he regarded crypto as a disgusting development and that those who promoted it were, in his view, either deluded or self-interested. He did not pretend that the asset class might be a legitimate innovation in payments or a hedge against monetary debasement; he treated it as a speculation that exploited the same incentive biases and psychology of crowds that had produced every previous speculative mania, and he refused to participate in any form. The avoidance principle, in Munger's telling, was not the absence of strategy. It was the strategy. The things he refused to touch - crypto, complex derivatives, structured products, financial engineering generally - defined the perimeter inside which he was willing to operate. The perimeter was deliberately narrow. The great investment decisions inside the perimeter - See's, Coca-Cola, BYD, Costco, the Japanese trading houses - had produced returns that an investor following the broader market could not have matched. The avoidance of the evil and the stupid was, paradoxically, what made the great investments possible.

Munger used the 2022 platform to restate his view of derivatives, the asset class he and Buffett had been warning about publicly since the 2003 meeting. He told the audience that the world had become more complex, more leveraged, and more interconnected since the original warning, and that the derivatives web had grown rather than shrunk in the intervening two decades. The systemic fragility had, in his view, become worse, not better. He did not predict a specific crisis; he predicted the pattern - that the next serious credit event would, as in 2008, propagate through the derivatives counterparty web faster than the regulators could contain it. The prescription was unchanged: stay simple, stay liquid, stay out of contracts whose payoff depended on a counterparty's solvency in a crisis. He told the room that Berkshire itself held a large cash position precisely because Buffett and Munger believed that the optionality of being able to act in a crisis was worth more than the small incremental return they would have earned by deploying that cash in calm markets. The cash was not a waste; it was insurance on the franchise. He closed with a callback to the avoidance principle. The investor who stayed out of the derivatives web, out of the crypto speculation, and out of the structured products would, in the next crisis, be one of the few people with both the capital and the courage to act. That was the actual content of risk management, in Munger's view - not the elaborate value-at-risk models that the banks ran, but the simple discipline of refusing to own assets whose behavior in a crisis could not be underwritten. The simple discipline, repeated over decades, was what produced the long-run record.

Munger used the 2020 meeting, with markets still in panic from the COVID crash, to restate his views on what works in a crisis. He had been through many of them. The way he operated in any crisis, he said, was the way he operated out of one: underspend your income, invest the difference patiently, do not panic, and stay in the few things you genuinely understand. He was telling the room not to confuse activity with courage. The heroic move in a crash is rarely to swing; it is usually to refuse to swing badly. He was unsentimental about the price of panic. He told the audience that the people who sold into the crash were going to be the people who paid the tax of being wrong about timing forever. The investor who held great businesses through the decline, who refused to mark his mental portfolio to the panic price, was the investor who kept his options open. He pointedly did not recommend buying the dip aggressively, because that, too, was a form of panic - just panic in the other direction. The discipline was to keep the steady habits when the tape was screaming at you. He closed the COVID thought with a Costco callback. The right thing in a crash, in Munger's view, was to have already chosen your Costco's before the crash arrived, so that when the world fell apart you did not have to make new decisions under pressure. The work was done in the calm years; the harvest was reaped in the violent ones. That was the actual content of patience, not the popular image of patient suffering but the engineering reality of pre-positioning.

We believe that none of the banks whose deposits are currently insured are facing significant risk of failure. This decrease in exposure to loss, of course, has caused a sharp decline in Kansas Bankers’ insurance volume, inasmuch as premiums from guarantee bonds not only approx- imated half of Kansas Bankers’ written premiums for 2008, but also represented the entirety of the business it had conducted in almost half of the states in which it was licensed to write insurance in 2008. The insurance business is highly competitive, with lengthy periods during which competitors offer coverages at prices we do not consider adequate. Kansas Bankers is now licensed to sell insurance in 29 states, down from 39 states one year earlier, with plans soon to withdraw from 4 more. We expect that Kansas Bankers will ultimately expand its premium volume, at prices deemed satisfactory. When Wesco purchased Kansas Bankers, it had been ceding almost half of its premium volume to reinsurers. In 2009 it reinsured only about 1%. And, because it has also restruc- tured the layers of losses reinsured, it is now better protected from the downside risk of large losses. Effective in 2006, insurance subsidiaries of Berkshire Hathaway became KBS’s sole reinsurers. Previously, an unaffiliated reinsurer was also involved. The increased volume of business retained comes, of course, with increased irregularity in the income stream. Kansas Bankers’ combined ratios were 140.2% for 2009, 111.6% for 2008 and 55.

4 billion, insuring 796 institutions at February 15, 2009, the first date that non-renewals and non-voluntary cancellations became effective. It is believed that few of the institutions Kansas Bankers insures are facing significant risk of failure. Because of aggregate limits as well as the purchase of reinsurance, the after-tax risk to Wesco from the failure of any single bank insured by Kansas Bankers is limited to a maximum of $7.6 million. Thus, we believe that Wesco’s shareholders’ equity is not significantly at risk as Kansas Bankers rapidly exits this line of insurance. This decrease in exposure to loss, of course, will cause a sharp decline in Kansas Bankers’ insurance volume, inasmuch as premiums from guarantee bonds not only approximated half of Kansas Bankers’ written premiums for 2008, but also represented the entirety of the business it has recently conducted in 16 of the 39 states in which it is licensed to write insurance. When Wesco purchased Kansas Bankers, it had been ceding almost half of its premium volume to reinsurers. In 2008 it reinsured only about 14%. And, because it has also restructured the layers of losses reinsured, it is now better protected from the downside risk of large losses. Effective in 2006, insurance subsidiaries of Berkshire Hathaway became KBS’s sole reinsurers. Previously, an unaffiliated reinsurer was also involved. The increased volume of business retained comes, of course, with increased irregularity in the income stream.

At the 2003 Berkshire annual meeting, Buffett and Munger issued what Buffett later called a wake-up call on derivatives. The ballooning and thoughtless use of risky derivatives contracts had, in their joint view, become a systemic danger. Munger's phrasing was characteristically blunt: he told the audience that the derivatives market had become a gathering place for weapons of financial mass destruction. The phrase was deliberately inflammatory, and Munger meant it to be. The argument was structural. Derivatives, in Munger's framing, did not just transfer risk - they magnified it, because the counterparty web was opaque and the mark-to-market process was unreliable. A financial system in which large institutions owed each other enormous notional sums, recorded at model prices rather than transactable prices, was a system in which the failure of one node could cascade unpredictably through the rest. The 1998 LTCM collapse had already shown the pattern; Munger and Buffett were telling the room that the pattern would recur at larger scale. The prescription was avoidance. Berkshire itself used derivatives sparingly and only when it could price them honestly - the equity put writtings of later years were a deliberate exception, undertaken only when the premiums and the structural terms were clearly attractive. For most institutions, Munger's view was that the right answer was to stay out of the contracts entirely, to refuse the short-term earnings boost they offered, and to accept that the apparent opportunity was a fee-generation mirage that would, in some future crisis, become a loss-generation machine.

Munger extended the derivatives critique into a broader indictment of modern financial engineering. The same incentives that produced the gallbladder surgeon - the man who had convinced himself that removing the organ was the right answer because the procedure paid him - produced the derivatives desk that built the structured product because the structured product paid the desk. The customer's interest and the seller's interest were aligned only at the surface; at the level of incentives, they were routinely in conflict. Munger told the audience to be deeply suspicious of any investment product created by professionals and aggressively merchandised. He tied the point to credit cycles. The derivatives web had grown during the easy-money years because the contracts looked profitable when credit was loose and counterparty risk was underpriced. When credit tightened, those same contracts would re-price violently and the unwinding would itself become a credit event. The derivatives problem and the credit-cycle problem were therefore not separate pathologies; they were two faces of the same pathology. Munger's prescription was to stay liquid, stay simple, and stay out of contracts whose payoffs depended on a counterparty's solvency in a crisis. He closed with a historical note. The Defense Department had, after enough experience with cost-plus-percentage-of-cost contracts, made it a felony for the federal government to write one. Munger took that as proof of concept: when a contract structure was so incentive-misaligned that even the government eventually criminalized it, the private sector's continued use of the same logic - in cost-plus mutual fund fees, in derivatives desks, in private equity carry - was not innovation but recidivism. The investor who recognized the pattern had a structural edge.

value as guessed in a similar calculation at the end of 1998. And, Ñnally, this reasonable-to-this-writer, $286-per-share Ñgure for intrinsic per share value of Wesco stock should be compared with the $245 per share price at which Wesco stock was selling on December 31, 1999. This comparison indicates that Wesco stock was then selling about 14% below intrinsic value. Wesco's investment portfolio suÅered more than its commensurate share of decline in market value in 1999. Last year, we said ""as Wesco's unrealized apprecia- tion has continued to grow in frothy markets for securities, it should be remembered that it is subject to market Öuctuation, possibly dramatic on the downside, with no guaranty as to its ultimate full realization .'' The stock of several of our largest investees lagged the market in 1999 by a large margin. It's no sure thing that the value of our marketable securities will quickly recover. Unrealized after-tax apprecia- tion represented 69% of Wesco's shareholders' equity at 1999 yearend, versus 76% and 73% one and two years earlier. Business and human quality in place at Wesco continues to be not nearly as good, all factors considered, as that in place at Berkshire Hathaway. Wesco is not an equally-good-but-smaller version of Berkshire Hathaway, better because its small size makes growth easier. Instead, each dollar of book value at Wesco continues plainly to provide much less intrinsic value than a similar dollar of book value at Berkshire Hathaway.

This approximation is made by simply adding (1) the value of the advantage from the interest-free ""loan'' per Wesco share and (2) liquidating value per Wesco share. Others may think diÅerently, but the foregoing approach seems reasonable to the writer as a way of estimating intrinsic value per Wesco share. Thus, if the value of the advantage from the interest-free tax-deferral ""loan'' present was $30 per Wesco share at yearend 1998, and after-tax liquidating value was then about $312 per share (Ñgures that seem rational to the writer), Wesco's intrinsic value per share would become about $342 per share at yearend 1998, up 25% from intrinsic value as guessed in a similar calculation at the end of 1997. And, Ñnally, this reasonable-to-this-writer, $342-per-share Ñgure for intrinsic per share value of Wesco stock should be compared with the $354∂ per share price at which Wesco stock was selling on December 31, 1998. This comparison indicates that Wesco stock was then selling about 4% above intrinsic value. As Wesco's unrealized appreciation has continued to grow in frothy markets for securities, it should be remembered that it is subject to market Öuctuation, possibly dramatic on the downside, with no guaranty as to its ultimate full realization. Unrealized after-tax appreciation represents 76% of Wesco's shareholders' equity at 1998 yearend), versus 73% and 70% one and two years earlier.

Daily Journal Corporation's late-1990s filings are notable for what they do and do not show. The company had, under Munger's chairmanship, avoided the speculative derivatives exposure that had destroyed several of its peers in the savings-and-loan and publishing-adjacent industries during the savings-and-loan crisis. The 10-K filings disclose a conservatively-financed publisher with a real moat - the appellate-decisions monopoly - and no exposure to the structured products that had ruined other ostensibly conservative companies in the same region. Munger's role at DJCO throughout the 1990s was, in effect, the same role he played at Berkshire: the disciplined refuser. He had refused to let Daily Journal take on the leverage that the cheap-money years of the mid-1990s had tempted other small public companies to take on. He had refused to chase the incremental yield that derivatives contracts appeared to offer. He had insisted that the company finance itself conservatively, hold its franchise honestly, and let the cash earnings of the legal publishing monopoly compound rather than leveraging them up in the name of growth. The retrospective lesson, visible in the 1997 10-K, was that avoidance was the operating decision. The companies that failed in the savings-and-loan crisis had not failed because they were stupid; they had failed because they had taken on exposure they did not need to take on, in pursuit of returns they did not need to pursue. Daily Journal, under Munger, had refused the exposure and survived the crisis with its franchise intact and its balance sheet clean. The same discipline would, two decades later, allow Daily Journal to pivot into court-automation software with the financial strength to absorb the long, slow, expensive slog of building that business. The avoidance had bought the optionality.

Thus, if the value of the advantage from the interest-free tax-deferral ""loan'' present was $25 per Wesco share at yearend 1997, and after-tax liquidating value was then about $248 per share (Ñgures that seem rational to the writer), Wesco's intrinsic value per share would become about $273 per share at yearend 1997, up 39% from intrinsic value as guessed in a similar calculation at the end of 1996. And, Ñnally, this reasonable-to-this-writer, $273-per-share Ñgure for intrinsic per share value of Wesco stock should be compared with the $300 per share price at which Wesco stock was selling on December 31, 1997. This comparison indicates that Wesco stock was then selling about 10% above intrinsic value. As Wesco's unrealized appreciation has continued to grow in frothy markets for securities, it should be remembered that it is subject to market Öuctuation, possibly dramatic on the downside, with no guaranty as to its ultimate full realization. Unrealized after-tax appreciation represents 73% of Wesco's shareholders' equity at 1997 yearend), versus 70% and 63% one and two years earlier. Business and human quality in place at Wesco continues to be not nearly as good, all factors considered, as that in place at Berkshire Hathaway. Wesco is not an equally-good-but-smaller version of Berkshire Hathaway, better because its small size makes growth easier.