Warren Buffet on Derivatives: Good For Me, But Not For Thee

Summary: Warren Buffett is warning that derivative securities are a "mega-catastrophe" and "financial weapons of mass destruction."

Warren Buffett is warning that derivative securities are a "mega-catastrophe" and "financial weapons of mass destruction" in the sneak preview of this year's annual letter to shareholders of Berkshire Hathaway, published in the latest Fortune:

[T]hese 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...

...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.

It's all the same stuff we seem to have to hear about derivatives every five years or so, about how derivatives are hard to value, about how they are rife with "systemic risks" and how about how positions are "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." The case of Long Term Capital Management is hauled out of mothballs, of course, to show how dangerous it all can be -- when LTCM is a textbook example of just the opposite: how a worst-case situation can, in fact, be handled successfully.

Now of course, in the obligatory "to be sure" disclosure, Buffett admits "Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies." And back in the 1992 annual letter, Buffett smirked about how simple derivatives are, when taking that view helped buttress his argument that executive stock options should be expensed in corporate income statements.

...options are just not that difficult to value... In fact, since I'm in the mood for offers, I'll make one to any executive who is granted a restricted option, even though it may be out of the money: On the day of issue, Berkshire will pay him or her a substantial sum for the right to any future gain he or she realizes on the option. So if you find a CEO who says his newly-issued options have little or no value, tell him to try us out. In truth, we have far more confidence in our ability to determine an appropriate price to pay for an option than we have in our ability to determine the proper depreciation rate for our corporate jet.

Get it? The guy with the corporate jet can "engage in large-scale derivatives transactions in order to facilitate certain investment strategies" -- and for him they're "just not that difficult to value." But for the rest of you grubby Wall Street strivers who think you can get your own corporate jet someday -- no way. Too dangerous!

Don Luskin is Chief Investment Officer for Trend Macrolytics. You can visit the weblog of his forthcoming book 'The Conspiracy to Keep You Poor and Stupid' at poorandstupid.com.

He is right. Some of this institutional betting on the economy has the potential to ruin whole sectors of the economy. A few unexpected market swings in interest rate and valuation and whole sectors of our economy will be paying the bad bets of a few. If it goes the other way they get rich. Either way only a few stand to gain and the rest of us have the potential to pay. I don't want financial institutions playing Enron. They shouldn't be able to make bets without being able to pay the bills and the bills here could reach into the stratosphere. Let them play with their own money and livelyhood.

Berkshire will pay him or her a substantial sum for the right to any future gain he or she realizes on the option.

Wait. Isn't that a limited risk option? If the value of the option goes up, Berkshire has realized a profit. If it goes down, they don't excercize. All of the obligation was limited to the initial payment. I thought Buffet was talking about the sorts of derivatives that have unlimited future liability.

IMHO, the biggest threat to the economy, and possibly our standard of living, are the rampant use of derivatives by major financial institutions. JP Morgan is one of the best examples I can think of. I have seen some reports that state they have a posision in derivatives large enough to collapse the company if things go the wrong way as they did at LTCM. When the economy was strong, Greenspan didn't have too much of a problem orchestrating a "bail-out", but now that over 7 trillion dollars have been wiped from the market ledgers, I don't think he will be able to pull it off again.

Buffet didn't get to be one of the world's richest men by playing with things that he doesn't understand. Options, when used properly, can reduce downside risk. What some of the large institutions are doing is using them for speculation.

Keep an eye on this old timer...he may have lost out on some of the big gains in the dot-coms, but he also didn't have his ass handed to him when they went into the toilet either.

>>the bills here could reach into the stratosphere.

I agree, the way things are now, any one of these big players who bets wrong, could be completely wiped out in a matter of days (i.e. enron) and bring with it all the other major players. None of them really understands the risks. A failure of a company like JPM could cause the entire house of cards to fall; and by that I mean the entire US economy with ripple affects throught the world. If it happens, it will likely all happen so fast there will be no time to get out and no safe place to hide.

Another down year or two in the market will likely uncover all kinds of shell games these comapnies have been playing in order to appear to be more profitable than they really are...if the markets fails to recover soon (and I doubt they will in any meanigful way); there will be no more hiding it.

You may want to check into what kind of derivatives exposure that your bank has. FDIC only has so much that it can cover.

Glass-Spiegel is gone and there are too many card-houses in the corporate world right now that would fall to dust if massive amounts of captial have to bail out the banks.

In general, I agree with the author that the word "derivatives" is often invoked (usually by people who are entirely ignorant of derivatives) to frighten people (who are just as ignorant.)

But calling Buffet a hypocrite here is a little unfair. There is a world of difference between calculating the value of vanilla stock options and managing the credit risk of a large OTC derivatives operation.

And the fact that LTCM was "handled", while reassuring, doesn't necessarily mean that the next LTCM won't cause a catastrophe. It showed that the risk is out there, probably where you would least expect it. We shouldn't panic and start over-regulating derivatives, but we shouldn't be complacent either. There will probably be another LTCM some day, maybe during a recession this time, and it may not be handled as easily.

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