What Worries Warren Buffett

Charlie [Munger, Buffett's partner in managing Berkshire Hathaway] and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.

Having delivered that thought, which I'll get back to, let me retreat to explaining derivatives, though the explanation must be general because the word covers an extraordinarily wide range of financial contracts. Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction--with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration (running sometimes to 20 or more years), and their value is often tied to several variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses--often huge in amount--in their current earnings statements without so much as a penny changing hands.

The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem--at a price, you will easily find an obliging counterparty.

When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie and I didn't want, judging it to be dangerous. We failed in our attempts to sell the operation, however, and are now terminating it.

But closing down a derivatives business is easier said than done. It will be a great many years before we are totally out of this operation (though we reduce our exposure daily). In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract--which may require a large payment decades later--you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability.

Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That's true because today's earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one's commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on "earnings" calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and "mark-to-model" is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

Of course, both internal and outside auditors review the numbers, but that's no easy job. For example, General Re Securities at year-end (after ten months of winding down its operation) had 14,384 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions.

The valuation problem is far from academic: In recent years some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great "earnings"--until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. "Mark-to-market" then turned out to be truly "mark-to-myth." I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multimillion-dollar bonus or the CEO who wanted to report impressive "earnings" (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we've been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

In banking, the recognition of a "linkage" problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a "chain reaction" threat exists within an industry, it pays to minimize links of any kind. That's how we conduct our reinsurance business, and it's one reason we are exiting derivatives.

Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies. Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by nondealer counterparties. Some of these counterparties, as I've mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems. Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM--a firm unknown to the general public and employing only a few hundred people--could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock, while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.

Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers, and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is running.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

Charlie and I believe Berkshire should be a fortress of financial strength--for the sake of our owners, creditors, policyholders, and employees. We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Citicorp and JP Morgan are among the largest dabblers in derivatives. To say that nobody understands the situation is an understatement, but the risk exposure MAY be in the trillions. Many of these contracts are laid off on other firms and balanced against each other, but as Buffet points out, that's not a watertight guarantee if your creditors all go belly-up.

that's why they're only used as a hedge that can be extremely effective for professionals in large volume trading environments. I, personally, don't deal in options and don't believe individual investors should do either as they're more likely employed as gambling than hedging activities.

Buffett, a gloom and doomer with a paradoxically sunny disposition, can be a little extreme in some of his more dour prognostications (e.g., the market will be "flat" until 2015), but no one can deny his overall financial genius. I would say his warnings about derivatives are well worth heeding.

"Utilizing covered call writing is a great benefit to a portfolio...."

The article did not draw a big enough distinction between exchance traded derivatives such as stock options and options on futures and non-exchange traded derivatives.

ETDs are traded in public markets with the counter party default risk being largely eliminated; because of the transparency price information financial institutions cannot hide losses easily with ETDs.

non-ETDs are another animal. In the past they have been lightly regulated because it was assumed that sophisticated parties making trades amongst themselves were well capable of assessing the financial and counterparty risk.

FASB needs to catch up with non-ETDs and promulgate rules that will force companies to honestly account for their non-ETD positions. The problem is not with non-ETDs per se but rather that slick traders have been able to fool accountants and auditors as the value of a particular position. The beancounters need to get ahead of the curve.

"Utilizing covered call writing is a great benefit to a portfolio. This is a riskless activity and actually protects against price declines."

That's not what the article is addressing or, at least, limited to. Covered call writing has been around forever. Fifty non-financial corp's like IBM each doing a $300million interest rate swap with a big broker dealer is the problem. If those swaps mature in say six or seven years, well, you know what they say: 'that put can break 6,7,8 times before it ever gets to the hole.

Utilizing covered call writing is a great benefit to a portfolio. This is a riskless activity and actually protects against price declines. In addition, using put writing when one has already decided to buy a stock is very valuable.

He isn't talking about CBOE positions but rather 110 trillion of illiquid sewage. Don't worry Bush just appointed a Neo-Keynesian as his economic advisor. I'm sure we can inflate our way out of 10+ GDP's of contagion.

qualification here - it should be a red flag to investors who are as good as Warren Buffett. he is effective enough in his investing strategy that he has no real need to hedge; remember he's one who's also of the practice to only invest in a very select few set of companies, himself, but advises the average investor is still well advised to more thoroughly diversify. the same thing applies at the higher level - Berkshire Hathaway has been very profitable with insurance and other investments largely due to his insight, methods and practice. how many Buffetts do you think AIG, C or the others have in their top echelon? 1, 2, maybe even zero? thus those other entities seek to balance their exposures anywhere, anytime, through hedging techniques and alternatives. again, these are not recommended or probably even necessary for the amateur or individual investor. but, note, interestingly enough, the folks repeatedly posting this article and its derivatives (pun intended) are the goldbugs and their disciples who've been reluctant to post Puplava or their other doom & gloomers, given the inevitable plunge in gold prices over the past couple weeks and no mention of John Bollinger's warnings over the same period that gold was primed for a collapse of $100 with the war pending and the possibility for even more losses in more accelerated fashion should the war go well and quickly for the USA.

Espicially Congress. Frank Partnoy, Professor of Law/ University of San Diego School of Law, submited testimony to the Committee on Governmental Affairs on January 24, 2002 during the Enron hearings. Here are a couple of paragraphs from his testimony:

"Derivatives based on credit ratings – called “credit derivatives” – are a booming business and they raise serious systemic concerns. The rating agencies seem to know this. Even Moody’s appears worried, and recently asked several securities firms for more detail about their dealings in these instruments. It is particularly chilling that not even Moody’s – the most sophisticated of the three credit rating agencies – knows much about these derivatives deals."

"If Enron had been making money in what it represented as its core businesses, and had used derivatives simply to “dress up” its financial statements, this Committee would not be meeting here today. Even after Enron restated its financial statements on November 8, 2001, it could have clarified its accounting treatment, consolidated its debts, and assured the various analysts that it was a viable entity."

Bad things a-coming:

Will Clinton be remembered as Herbert Hover??

Will Bush be the next FDR (anti-FDR) and finally unravel the mess that began with the first Great Depression??

Everything is circular, and perhaps now that socialism is dying everywhere in the world it is time that it whimpers out for good.

Why persist with the erroneous statement that Keynes was an inflationist? He wasn't. Keynesianism as practiced today is not what he had recommended. Have you ever read the General Theory of employment, interest and money? Or do you rely on mistatements of others ideas?

Keynes certainly had nothing to do with the creation of financial derivatives. Nor does his theoretic framework have a means of handling them.

Why persist with the erroneous statement that Keynes was an inflationist? He wasn't.

In theory, he wasn't, but in practice this is the result of Keynesianism. This is no mistake. Keynes despised Western civilization but hid this contempt behind a facade of altruism just as he hid his habit of raping children behind the facade of his heterosexual marriage. He knew that socialism could be used to destroy Great Britian.

Keynesianism make Socialism economically viable by preserving private ownership while allowing for central planning and control. This combination of private profit with socialized risk is precisely what leads to the problems emerging in our banks, GSEs, agricultural markets, health care markets, etc, etc.

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