Warren Buffet on Derivatives

Discussion in 'Options' started by luh3417, Oct 3, 2005.

  1. luh3417


    Warren Buffet on Derivatives

    Following are edited excerpts from the Berkshire Hathaway annual report for 2002.

    I view derivatives as time bombs, both for the parties that deal in them and the economic system. Basically 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. For example, if 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 counter-parties to them. But before a contract is settled, the counter-parties record
    profits and losses – often huge in amount – in their current earnings statements without so much as a
    penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for
    many years.

    The errors usually reflect 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, 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 counter-parties to use fanciful assumptions. 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.

    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 multi-million 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 counter-parties. 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 counter-parties tend to build up over time. A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. However under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z.

    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.

    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.

    On a micro level, what they say is often true. 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 other. The troubles of one could quickly infect the others.

    On top of that, these dealers are owed huge amounts by non-dealer counter-parties. Some of these
    counter-parties, are linked in ways that could cause them to run into a problem because of a single event, such as the implosion of the telecom industry. 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.

    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. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
  2. Luh3;
    Note the huge difference between a comma [,] and one[1]word.

    I wouldnt have you ignorant bro;
    I wouldnt have you ignorant, bro

    We trade ''regulated ''derivatives
    John Henry commenting on Warren Buffet article:cool:
  3. dont


    What Buffet says is exactly right its not derivatives themselves, that are the problem, its the abuse thats the problem.
  4. the more this is discussed, the better the market is able to price the risk involved.
  5. There is absolutely nothing wrong with derivatives. Cannot blame derivatives if people use them incorrectly or they have enormous margin/leverage and has been kept that way. Long-term Capital Management abused deriviatives and over leveraged themselves. The products worked exactly as they were supposed to but the people using them were idiots. Nobel Prizes aside, when you ignore risk management and leverage yourself 100 times and become the market, you are an idiot. Long-term was allowed unbridled leverage and margin by all the investment banks and they should have went under with LTCM to learn their lesson, but it would have been too devastating.

    Buffet is also a hypocrite because his last few annual reports show billions in derivatives. Now I am sure a nice chunk of that is General Re his subsidiary but he knew that when he bought it and does not complain when they make him money. Also he has a ton of options, forwards, swaps and futures contracts with notional values in the billions.

    Buffet is a do as I say not as I do kind of person and I wish everyone would stop treating his words as gospel, he presents only one point of view.
  6. I think it should be clarified here that there is a big difference between derivatives contracts with a clearing house as the counterparty and contracts where another bank or insurance company is the counterparty (OTC).

    The clearing house has a large pool of capital to draw on and forces participants to mark to market everyday and put up sufficient performance bond to maintain these position. This system was tested by a nearly worst case scenario in LTCM and was able to hold up.

    Now if the counterparty is a insurance company that enters into contracts based on receiving premiums as part of on going business the risk profile of derivatives contracts can change drastically. GEICO will have a lot of contracts with AIG. Let say that AIG has a lot of it's trades with SwissRe go against it at the same time the numbers of policies written goes way down. Next thing you know S&P downgrades AIG and a downward spiral begins. All of a sudden Warren's GEICO is worried about having their contracts honoured and guess what their cost of capital goes up.

    You can see how there is a moral hazard it you are the CEO of a big insurance company. You can make a huge bet in the OTC derivatives market and if you win you get a huge bonus, and if you lose you get you salary. And the best part is that these contracts are so opaque that nobody really know that you doing this as it happens.