What Worries Warren Buffett

Buffett (and the gold bugs) are not the only ones concerned about derivatives:

Risk rises at European regional banks
By Jenny Wiggins in New York
Published: March 9 2003 20:41 | Last Updated: March 9 2003 20:41

http://news.ft.com/servlet/ContentServer?pagename=FT.com/StoryFT/FullStory&c=StoryFT&cid=1045511461181&p=1012571727088

European regional banks have taken on a lot more risk than their public accounts show because of heavy exposure to credit derivatives, according to new research.

Three-quarters of the European banks surveyed in a report by Fitch, the credit rating agency, have sold about €50bn of credit protection to other parties.

Half of these banks were German, with the state-owned Landesbanken being particularly active.

They have increased their exposure to high-yielding derivatives to offset flagging profits in traditional lending businesses. Fitch says it may cut the credit rating on banks with large exposures to credit derivatives.

The Fitch report follows last week's warning from Warren Buffett, the influential US investor, that derivatives represented "financial weapons of mass destruction" and are "potentially lethal" to the economic system.

Fitch said the European banks' exposure to credit derivatives was surprising because banks typically buy credit protection to reduce risk. Institutions that sell protection on a bond or loan using a credit derivative assume the underlying credit risk of the security.

Although European banks are net buyers of protection, with about €65bn purchased, the bulk of the buying has been undertaken by a few large institutions. Only 30 per cent of European banks active in the credit derivatives market are protection buyers.

Fitch has spent three months trying to quantify financial institutions' exposure to credit derivatives but has been only partially successful. Some institutions have refused to disclose information about their derivative activities.

"We need more financial transparency," said Roger Merritt, Fitch analyst and co-author of the report, to be released today.

Fitch plans to meet with global regulators to encourage more disclosure of credit derivatives activity.

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

I wouldn't call it risk less. A star in your portfolio could be assigned.

I buy stocks specifically to sell call contracts (usually at/near or in-the-money) with the intent of them being assigned, and can typically make 5% in 30-45 days with 10+% downside protection. If they drop too much below the strike price before expiration I may have to buy back the option liability before selling the stock at a loss. Admittedly not much of a loss, and in some cases I sell the stock and hold the options contracts naked, letting them expire worthless, and come out ahead. But it is a great way to make a living! Put and Call credit/debit spreads and the like can be even more lucrative.

I view covered calls as a means of reducing the risk of holding stocks at a minimum and as a positive means of earning income through the premium. My return, not counting capital gains, is between 15-20% and I also do not buy stocks to hold specifically. But don't mind keeping them if they generate consistently good option premium income.

I don't understand your reference to "a star in my portfolio." When I am doing this on my own account I do as you mention but for the portfolio I manage for my church do not because of the unlimited risk or even the slight increase in risk which those strategies impose.

I have been using selling puts as a means of purchase of
stocks you want to buy or just get the premium if it expires.

I may be misunderstanding your strategy, but when I said you may lose a star in you portfolio, I meant that if you write call options on a stock you hold (covered calls), if the price of the stock goes above the strike price, it will be assigned (your broker will sell the stock at the strike price) when the option expires. Of course, you could always buy the option back before that happens.

You have freep mail.

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