It’s no secret that financial derivatives played a key role in the global financial crisis. Although many derivative products have value as hedging tools, their complexity can make it difficult to figure out the relationships between various counterparts. Additionally, the leverage inherent to many such contracts can magnify a company’s risk significantly.
This combustible mixture of complexity and leverage is one reason why Warren Buffett (Trades, Portfolio) believes they are dangerous, referring to them as “financial weapons of mass destruction.” In his 2008 letter to shareholders of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), Buffett discussed how they massively increased the risks in the financial system.
Indecipherable and opaque
Buffett said derivatives made it impossible for investors to accurately assess the risk held by institutions such as Fannie Mae and Freddie Mac:
“They [derivatives] allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years. So indecipherable were Freddie and Fannie that their federal regulator, OFHEO, whose more than 100 employees had no job except the oversight of these two institutions, totally missed their cooking of the books.”
The problem wasn’t just that some executives and staff were misleading regulators (although that certainly didn’t help). The much bigger issue is that even with perfectly transparent disclosure, the potential fallout of so many interconnected positions is almost impossible to estimate.
“Improved 'transparency' – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them. When I read the pages of 'disclosure' in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don’t know what is going on in their portfolios (and then I reach for some aspirin).”
Another problem pointed out by Buffett is time. Most trades in equities or fixed income are closed within a few days. This limits counterparty risk, as once the transaction is completed, no one owes each other anything else. This is not the case when it comes to derivatives:
“Derivatives contracts, in contrast, often go unsettled for years, or even decades, with counterparties building up huge claims against each other. 'Paper' assets and liabilities – often hard to quantify – become important parts of financial statements though these items will not be validated for many years. Additionally, a frightening web of mutual dependence develops among huge financial institutions. Receivables and payables by the billions become concentrated in the hands of a few large dealers who are apt to be highly-leveraged in other ways as well. Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with.”
Unfortunately, this fact was well known by many big executives in the run-up to the crisis. By building up impossibly labyrinthine derivatives positions, they ensured the government would have no choice but to bail them out. Not doing so would have put the stability of the financial system at risk (though looking back, one might argue that has simply compounded the problem of moral hazard). Buffett sums this idea up very neatly:
“Modest incompetence simply won’t do; it’s mind-boggling screw-ups that are required.”
Disclosure: The author owns no stocks mentioned.
Read more here:
- Morgan Stanley: 3 Sources of Uncertainty
- Sam Zell: Try to Avoid Competition
- Corporate Debt Is a Time Bomb
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