[HIMC] Warren Buffet: Derivatives as financial "weapons of mass destruction"

[Jon Frederick]

If you've read that the derivatives market is a "time bomb" for the
economy, or that slight-of-hand accounting involving derivatives is often
used to mistate corporate earnings and defraud shareholders, you might
have had trouble understanding how these complex financial instruments
work. Here's an article by some famous rich white guy that explains the
concepts involved, in something approximating plain English.  --JF


http://www.fortune.com/fortune/investing/articles/0,15114,427751,00.html

WHAT WORRIES WARREN
Avoiding a 'Mega-Catastrophe'
Derivatives are financial weapons of mass destruction. The dangers are now
latent--but they could be lethal.
FORTUNE
Monday, March 3, 2003
By Warren Buffett

Warren Buffett has been writing annual letters to Berkshire Hathaway
shareholders since 1965. In the early years he followed a conventional
format, but after serving on the SEC Advisory Board for Corporate
Disclosure in 1976, he decided--as he puts it--to "get serious" about
communicating with his shareholders.

He made another important decision in 1977: to recruit FORTUNE's Carol
Loomis, a friend and long-term Berkshire shareholder, to be his editor.
Buffett says she has been invaluable--"very friendly, very helpful, and
very tough."

In this year's letter to shareholders Buffett tells of the difficulties of
exiting the derivatives business he inherited in his 1998 purchase of
General Re. He also concludes that the explosion in derivatives contracts
may have created serious systemic risks. Loomis suggested to Buffett that
he publish his section on derivatives in FORTUNE, and what follows is
excerpted from the 2002 Berkshire Hathaway annual report, which will
appear at berkshirehathaway.com on March 8.

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.