Buffet on derivatives

Warren Buffet’s views on derivatives are well-known- time bombs, weapons of mass destruction etc. I read Berkshire Hathaway shareholder report -2002 (page 13- 15) where these Buffet euphemisms for derivatives are mentioned.

Apart from these select words, Buffet has highlighted risks from these instruments. At hindsight, these are the very risks which have led to the recent collapse. Sample this:

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.

He says if you want a derivative speculating on number of twins to be born in Nebraska in 2020 you can have it

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.

On mark to market:

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.

He then discusses how derivatives lead create a daisy chain (i call it a house of cards) leading to a collapse from A entity to Z entity. He also says they continue to expand and central banks haven’t developed ways to monitor the risks. His take on risktaking is enough of a alarm (even now):

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

If he doesn’t understand, I am not sure who would??

Finally the famous words:

In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.