What is Charlie Munger's stance on 'financial engineering'?
Charlie Munger's View on "Financial Engineering": Profound Scorn and Vigilance
Charlie Munger holds an extremely negative and critical view of "Financial Engineering." He believes that the vast majority of financial engineering not only fails to create real value for society but also breeds enormous systemic risk, moral hazard, and unnecessary complexity.
In summary, his perspective can be distilled into the following core points:
1. Financial Derivatives are "Weapons of Mass Destruction"
This is one of Munger and Buffett's most famous assertions. They argue that financial derivatives, represented by options, futures, swaps, credit default swaps (CDS), etc., have risks that are difficult to account for and measure. These risks cascade through the financial system, creating vast, opaque, and interconnected exposures. If one link fails, it can trigger a chain reaction like dominoes, potentially collapsing the entire financial system. The 2008 financial crisis stands as the prime validation of this view.
"I regard them (derivatives) as 'financial weapons of mass destruction,' carrying dangers that, while now latent, are potentially lethal to the economic system."
2. Aversion to Unnecessary Complexity
Munger is a staunch believer in "simplicity" and "common sense." He contends that the core of financial engineering is making simple things complex, creating financial products that even their designers may not fully understand. This complexity often serves not to create value, but to:
- Obfuscate: Make it difficult for investors and regulators to discern the true risk and value of the product.
- Hide Leverage: Conceal massive leverage behind intricate structures.
- Charge Exorbitant Fees: Investment bankers can levy hefty commissions and management fees for these "sophisticated" products.
He believes a good business model should be simple, clear, and easy to understand. If you can't understand something, it's best to stay away from it.
3. Criticism of Accounting Manipulation and "Phony" Profits
Much financial engineering is used to manipulate financial statements, particularly to smooth or artificially inflate Earnings Per Share (EPS). Munger detests this practice. He believes the purpose of accounting is to truthfully reflect a company's economic reality, not to serve as a tool for management to deceive investors. He strongly criticizes companies that use complex accounting tricks (like "Pro-forma Earnings") to window-dress performance, viewing it as dishonest.
4. Concern Over Perverse Incentives
Munger often says: "Show me the incentive and I will show you the outcome." He identifies Wall Street's incentive structure as the root cause of the proliferation of financial engineering. Investment bankers reap huge short-term bonuses for designing and selling complex products, but the long-term risks of these products are borne by company shareholders and even society at large. This model of "heads I win, tails you lose" inevitably encourages extreme risk-taking and irresponsible behavior.
5. A Nuanced View on "Stock Buybacks"
Stock buybacks themselves can be considered a form of financial engineering. Unlike his blanket condemnation of other financial engineering, Munger holds a nuanced view on this practice.
- Supports Rational Buybacks: When a company's stock price is significantly below its intrinsic value, using cash to repurchase shares is one of the most beneficial capital allocation methods for shareholders. Berkshire Hathaway itself has conducted large-scale buybacks.
- Opposes Foolish Buybacks: He vehemently opposes companies repurchasing shares when the stock is overvalued, solely to boost EPS. He views this as destroying shareholder value and a foolish decision by management to cater to short-term market expectations.
Summary
In Munger's view, the term "financial engineering" is largely synonymous with "financial trickery." It represents a dangerous tendency that has deviated from the original purpose of serving the real economy, instead pursuing arbitrage in games of numbers and models. He champions an investment philosophy grounded in common sense, patience, honesty, and a deep understanding of intrinsic business value – principles fundamentally at odds with most financial engineering. He believes a healthy economy needs more excellent engineers, doctors, and entrepreneurs, not more "financial engineers" designing complex derivatives at their computers.