The Concept of Risk has Been Forgotten - Buffett's Dictum & Your Margin of Safety

By: Adrian_Ash

"...Risk has been abolished – a concept even the TV news anchors can grasp..."

"IF YOU UNDERSTOOD a business perfectly and the future of the business, you would need very little in the way of a margin of safety," said Warren Buffett at Berkshire Hathaway's annual meeting in 1997.

He had first issued his famous dictum twenty years earlier. Buffett referred to it again in 2005.

"We [only] borrow money against portfolios of interest-bearing receivables whose risk characteristics we understand," he told his shareholders...and the BRK faithful just loved it.

Understanding where you're putting your money – knowing how it will be used, and knowing the likelihood of getting it back – reduces your risk, in short. If you don't understand an investment, then the "unknown unknowns" threaten to eat you alive.

Appears sound in theory, right? But does anyone outside of Gorat's steakhouse today even begin to care if it's true?

"Although the dislocations, especially to short-term funding markets, have been large and in some cases unexpected," the International Monetary Fund just reported, "the event [of the world credit crunch] hit during a period of above-average global growth."

Moreover, added Rodrigo Rato, the IMF's managing director, in a Moscow press conference Tuesday, "the evolution of recent days is moving towards normalization."

"The most important financial institutions have enough capital to withstand the shock," Rato explained. And amid the crisis in confidence and "state of turbulence" hitting the financial sector, "we welcome the actions of central banks to maximize liquidity," he announced.

Trouble is, maximizing liquidity – the availability of money – is what created this mess in the first place. Failing to understand this plain fact is what led the United Kingdom , the world's fourth largest economy, to suffer its first genuine banking run in more than a century. Here in London , all progress in finance since 1878 just got wiped out.

Yes, the City and its regulators have swapped whiskery chops and black stove-pipe hats for ShockWave hair gel and pink gingham shirts. But they're no more "sophisticated" than were their Victorian forebears. And as the IMF report proves, it's not only London that's failed to grasp the risks facing global finance today.

The run on Northern Rock (NRK) came thanks to the very "liquidity" that Rodrigo Rato of the IMF says he's glad to see pouring out of central banks once again. NRK was a top-five mortgage lender that gathered £24 billion in saving deposits but lent out £113 billion. It raised the difference by borrowing short-term funds in the money markets.

Did anyone inside Northern Rock understand the risks inherent in "maximizing liquidity" so aggressively? Didn't the Bank of England or Financial Services Authority grasp the dangers this high-profile bank was storing up on its balancesheet? Evidently not – and why would they?

By the end of June, NRK's total exposure to subprime US home-loans represented only 0.24% of its total assets. Hot on the heels of the Bear Stearns' hedge-fund collapse at the start of the summer, this meant NRK was deemed safe from the chaos of failing mortgage-backed bonds relying on low-income US home-buyers for repayment.

Not that London 's financial leaders were alone in their error. The mass of British investors also mistook NRK's tiny subprime exposure for evidence that it was safe. NRK was one of the five most popular shares bought by private UK investors in the last week of August. Since then, however, NRK's stock has sunk by 75%.

Pictures of anxious savers queuing outside NRK's branches on the High Street also destroyed confidence in the Bank of England and Financial Services Authority – the government-mandated watchdogs supposed to understand, monitor and cap its risky behavior. The media's panic, shocked at the very idea that a financial firm might ever go under, then forced London 's government of amateur financial idiots to guarantee all savings for all savers wherever they bank.

Risk has been abolished, in short – a concept even the TV news anchors can grasp. So who cares that it's not true?

"Whatever system is put in place to safeguard [UK bank] deposits following the run on Northern Rock," says a letter to the Financial Times , "it is important that it is understandable to savers. I wonder how many savers understood the workings of the Financial Services Compensation Scheme before its recent coverage in the press?"

The British equivalent of the FDIC, this Compensation Scheme – it was revealed Tuesday – now holds funds of just £4.4 million. Total UK bank deposits, on the other hand, total some £1.6 trillion. It doesn't matter that, in the wholly unlikely event of a total collapse in British banking, the fund could offer only 0.00002% in compensation. Forget the fact, too, that the US insurance scheme by comparison holds 5,000 times as much cash for a population only five times the size.

The point is that the FSCS in London was allowed to promise insurance worth £31,700 to each of Britain's cash savers (just less than $64,000) – and to continue making this promise – without anyone bothering to even imagine that the policy might ever needed.

The United Kingdom also has the Banking Code, a 36-page document setting out standards of behavior agreed by the vast majority of retail banks and building societies. But the state-owned monopoly Post Office has yet to sign up to the Code. And the Code itself does not mention the word "risk" once. Nor does it talk about "safety". The sole preoccupation, as with today's bubble-friendly banking regulations everywhere, is with honesty in marketing.

Honesty about the raw fact of banking deposits – that your money is at risk the moment you let someone else lend it out for a profit – just doesn't figure.

In the United States too, the very concept of "risk" has been long forgotten as a warning. Indeed, for Bank of America's current marketeers, it's now just a tool...a branding technique to prop up tired advertising exec's when they're all out of ideas.

The biggest bank in the US currently offers what it calls the "Risk Free CD". Never paying less than 4.75% during its 11-month term, the Risk Free cash deposit actually comes with no more, or less, risk than any other US savings account. It's only claim to safety is that you can "count on the security of FDIC insurance up to $100,000 on your accounts," says the marketing blurb.

Yes, that's it! Beyond the FDIC promise, the risks to your money are no different to the risks incurred by holding your cash anywhere else. The "risk free" sticker on BoA's "Risk Free CD" is simply there to make 4.75% interest sound unique, intriguing, perhaps even attractive.

But who outside Wall Street, the City, Frankfurt 's glass towers or Tokyo 's Kabutocho district can understand that? Who on the inside even cares?

By Adrian Ash
BullionVault.com

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City correspondent for The Daily Reckoning in London and a regular contributor to MoneyWeek magazine, Adrian Ash is the editor of Gold News and head of research at www.BullionVault.com , giving you direct access to investment gold, vaulted in Zurich , on $3 spreads and 0.8% dealing fees.

(c) BullionVault 2007

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it.

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