Financial derivatives have a long and fascinating history. The earliest derivative-like products date back to as early as Mesopotamian times, when merchants would enter into contracts for future delivery of commodities (what would today be called forward contracts, and their standardized offspring, futures). In the 16th century, derivatives on securities began to emerge.
Since then, they have grown to cover every conceivable type of risk. Typically, it is thought that derivatives move risk from those less able to bear it to those more able to bear it. As we saw during the 2008 financial crisis, however, what works in theory does not always work in practice.
At the 2003 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual shareholder meeting, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) took some time to discuss the risks financial derivatives pose to the system and how they can fail in their stated purpose as risk-reducers.
Indeed, Munger’s prediction of a derivative-catalyzed blow-up within the next five to 10 years seemed eerily prescient:
“In engineering, people put big margins of safety into systems, atomic power plants being the extreme example, and in the financial world with derivatives, it’s as if nobody gave a damn about safety... And I’m more negative than Warren in the sense that I’ll be amazed if I live another five or ten years, if we don’t have some significant blow-up.”
Although the 2008 financial crisis had its genesis in the collapse of the U.S. housing market, it never would have resulted in the catastrophic outcome that took place if systemically important financial institutions hadn’t been using derivatives to gain exposure to the market in a highly-leveraged way. Buffett explained how this concentration of risk tends to occur when derivatives become widely used:
“I would say that I think they have long crossed the point where they reduce risk for the system, and that now they enhance it. The Coca-Cola Co. (KO, Financial) can bear the foreign exchange risks that they run, or the interest rate risks that they run and all of that sort of thing. But when the Coca-Cola Co. starts laying those off, and every other major company in the world does [likewise] with just relatively few players, you have now intensified the risks that exist in the system,”
In his book, "The Ascent of Money," financial historian Niall Ferguson distills the problem with derivatives. He said that, in theory, risk should be moved to those able to bear it. In practice, it was moved to those least able to understand it, which is why municipalities in places as far away as Norway were adversely affected by the inability of homeowners in Louisiana to service their mortgage payments.
This is the point Munger and Buffett were making. Big companies should be able to bear risk. But if given the option, they will attempt to lay it off to other institutions. And when everyone starts doing the same thing, the risk of a large number of diverse companies is concentrated on the balance sheets of a few systemically important institutions. That is a recipe for disaster.
Disclosure: The author owns stocks mentioned.
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