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

by | Mar 4, 2003

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 […]

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!

Warren’s climbed up into his jet and pulled the ladder up after him.

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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