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Articles on derivatives
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
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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,
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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.
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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.
Financial WMD?
1,346 words
24 January 2004
The Economist
English
(c) The Economist Newspaper Limited, London 2004. All rights reserved
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Derivatives can reduce many risks, except the human kind
IN MANY people's minds, derivatives - those obscure financial contracts peddled by the maths
wizards of Wall Street and the City of London - have become synonymous with financial risk.
That seems odd when you consider that they are designed to shift risk precisely from one party to
another. In theory, that should help to make investors safer from financial storms.
Derivatives hit the headlines in the 1990s when Orange County, an upmarket suburb of Los
Angeles, went bust because it had used them inappropriately. Procter & Gamble, a staid maker of
household goods, and Gibson Greetings, a mid-western greetings-card maker, also lost heavily
on derivatives. And those were only the biggest debacles.
The use of derivatives by governments, in particular, carries risks that have received too little
attention, says Benn Steil of America's Council on Foreign Relations. Governments have
employed these instruments mainly to tap cheap capital, but it all depends on how they set about
it. Sweden is known as an active and sensible user of such programmes. The Italian government,
on the other hand, has recently been criticised for its highly creative use of an interest-rate swap.
According to a report for the International Securities Market Association (ISMA) by Gustavo
Piga, the government seems to have used derivatives to mask the size of its debt.
Last year, Warren Buffett, America's most famous investor, launched a new tirade against
derivatives, calling them "financial weapons of mass destruction." He was joined by Bill Gross,
the manager of PIMCO, a multi-billion-dollar bond fund. They and other critics charge that
derivatives contracts contain dormant losses that will come to haunt their owners, typically
insurance companies and banks. The critics also claim that derivatives enable corporate
treasurers to gamble with shareholders' money.
There is something in this. Only last summer, Freddie Mac, America's giant government-
chartered and shareholder-owned mortgage firm, announced that it was restating its profits for
the past few years. The culprit turned out to be the derivatives the firm had used, ostensibly to
smooth the effects of see-sawing interest rates on its mortgage business.
The good, the bad and the ugly
Derivatives are not exactly new - Japanese rice traders, for example, used futures in the 17th
century - but they have become much more sophisticated in recent years. The modern toolbox
consists mainly of futures and forwards (agreements to buy an asset in the future at a fixed
price), options (which give you the right, but not the obligation, to buy an asset, say a share or a
lump of foreign currency, in the future at an agreed price) and swaps (which enable you to
exchange a future string of payments in one currency for one in another).
Such financial instruments, and combinations of them, come in two types. The first is the listed
variety, such as call options (the option to buy) and put options (the right to sell) written on
shares in the stockmarkets. The second, and by far the biggest, group is over-the-counter (OTC)
derivatives, which are arranged between two parties. The outstanding value of OTC derivatives
has been growing rapidly for the past 20 years (see chart 5).
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Those that have caused most of the trouble make up only a small part of the total market. They
are called exotic options, and have been responsible for many of the debacles in the 1990s, as
well as for the troubles at Freddie Mac today. They are often so complicated that it takes a PhD
in maths and days of computer time to find out whether you have made a fortune or gone bust.
Perhaps as a result, the popularity of exotics has waned somewhat.
What makes derivatives so useful, despite the dangers, is that they allow an ever widening array
of risks to be traded. Weather derivatives, for example, can be written so that they will pay out if
the temperature rises above a certain figure, which could be a boon for an electric utility in the
summer, or if snowfall during the winter is lower than expected, which could help a ski resort.
In 2002, Goldman Sachs and Deutsche Bank set up a scheme to trade economic derivatives,
which give punters a chance to take bets on the direction of macroeconomic variables such as
unemployment and inflation. Speculators may view this as just another opportunity to take a
punt, but the longer-term hope is that such markets can help lay off more fundamental economic
risks. Trade unions, for instance, might buy an unemployment derivative to protect themselves
against the consequences of their members losing their jobs. Robert Shiller, of Yale University,
wants to see that kind of derivative widely used (see box).
However, bankers have become very concerned about financial derivatives again, much as they
were in the mid-1990s (see table 6, next page), according to a poll from the Centre for the Study
of Financial Innovation. Like Messrs Buffett and Gross, they are particularly bothered about
credit derivatives, more than about bad lending and poor bank management, the more usual
banker's nightmares.
A credit derivative is a corporate contract that pays its holders if a certain company goes bust.
The idea is that if you own a credit derivative for, say, General Electric (the "name"), and GE
declares default on its debt, you will get paid. This is especially handy if you already own some
of GE's bonds: the credit derivative can help limit your losses, in the same way that an insurance
policy would. Such contracts have been booming in the past five years.
But will they pay up?
One particular cause for concern is counterparty risk - the possibility that people holding credit
derivatives will not get paid by those who issued them. Credit derivatives are largely
unregulated, so no one knows what would happen if there were lots of defaults. Another worry
has to do with the legal structure of credit derivatives. They often fail to lay down clearly what
would constitute a default for the purpose of triggering payment to holders of such derivatives.
Mr Gross - along with the bankers - fears that credit derivatives could make the markets for
corporate debt more jittery rather than stabilise them.
Mr Buffet's grouse is more practical and immediate. A few years ago Mr Buffett's firm,
Berkshire Hathaway, bought General Re, an insurance firm, which like other big insurers and
reinsurers had piled eagerly into the credit-derivatives market. But when the economic downturn
came, such firms found they had to pay out billions, and General Re was hit especially hard.
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Alan Greenspan of America's Federal Reserve, however, was having none of Mr Buffett's
complaints. He quickly stepped in to praise credit derivatives for shoring up the stability of the
global financial system. If insurance companies had chosen to sell protection on corporate debt
of their own free will, that was their business.
Some derivatives, however, do seem to lend themselves particularly well to nefarious purposes.
Their very complexity makes them perfect for foiling the rules of the equally complex tax codes
of most rich countries. For example, they can be used to turn a capital gain into a temporary loss,
a dividend or any other type of income that the taxman treats leniently. America's tax police are
trying to crack down on this kind of thing.
America's accounting watchdog, the Financial Accounting Standards Board (FASB), has
introduced a new rule requiring companies to show whether they are using derivatives to hedge
risks connected to their business, or whether they are just taking a risky bet. Genuine hedging,
such as an airline buying forward against a rise in the price of jet fuel, is spared scrutiny, but less
obvious hedges have to be carried on a company's books at their market value. This can cause
wild fluctuations in a firm's income, so the rule should discourage the sort of punts that lack any
clear economic logic.
Derivatives for everyday life--the missing market
387 words
24 January 2004
The Economist
English
(c) The Economist Newspaper Limited, London 2004. All rights reserved
DERIVATIVES have been good for the big investment banks that sell them, and sometimes
helpful to the companies that use them. But what about the man in the street? He will soon get
his chance, if Robert Shiller has his way.
Mr Shiller, a professor at Yale University and author of a book entitled "Irrational Exuberance",
which in 2000 foretold the bursting of the stockmarket bubble, imagines a glorious future for
personal finance. He predicts the rise of financial innovations that will help to take the risks out
of everyone's lives.
Why, he asks, are there so few markets for hedging the most common types of risks people face?
For example, you can buy disability insurance to protect you if illness prevents you from
working, but not "livelihood insurance" to compensate you if your chosen career does not
flourish. You can buy fire insurance in case your house burns down, but not "value insurance"
that pays out if the market value of your house falls.
One problem with this kind of novel security would be "moral hazard": the risk that, knowing
they are insured, people will take less care to prevent the calamity in question. Insurance
companies calculate that drivers will be more reckless if they know that someone else will pay
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for repairs. Similarly, people might work less hard if they knew they were insured against loss of
livelihood.
Another problem is that traditional kinds of insurance (eg, fire, disability) affect relatively few
people, although the loss to each of them may be large. A non-traditional insurance may pay out
on much smaller individual losses, say a 5% decline in house prices, but may be spread far more
widely, so the overall sums involved could be enormous. Who would be willing to bear that risk?
Mr Shiller dismisses these worries, pointing out that when fire insurance was first mooted, critics
used the same arguments to predict that it would never take off. He hopes that these new
financial products might lead to a flowering of human talent. By lessening the risk, it might
encourage more students to become, say, violinists or research scientists rather than lawyers or
accountants. Perhaps. Meanwhile, Mr Shiller's son hopes to apply for a place on an MBA course.
Better Living Through Derivatives?
By David Wessel
873 words
9 September 2004
The Wall Street Journal
PRESIDENT Bush says his "ownership society" will let you "make your own choices and pursue
your own dreams." If he can persuade Congress, he says, "More people will own their health
plans and have the confidence of owning a piece of their retirement."
Put another way, Mr. Bush would have government and employers take less financial risk -- and
American households take more. In the "ownership society," your retirement will depend even
more than it already does on picking the right mix of stocks and bonds, correctly anticipating
inflation and prudently projecting the length of your life.
There are arguments for the shift Mr. Bush advocates. People who know their retirement depends
heavily on their saving will save more than those who count on Social Security and corporate
pensions, and the economy's prospects would be better if Americans saved more. People who
pay more of their health-care costs may be more judicious in spending, and the U.S. economy
would benefit if Americans were smarter health-care consumers. And the elderly in a society
with two workers per retiree will have to share more risk of bad times than those lucky enough to
retire in an era with seven workers per retiree.
Still, is it a good idea to force American families -- including those without much wealth or
financial savvy -- to take more of the risk that stock and bond markets will turn sour, that
inflation will surprise, that they will outlive their savings, or that college tuition will rise even
faster than anticipated?
Robert Merton, the Harvard Business School finance professor who shared the 1997 Nobel Prize
in economics, doesn't think so. He sees an alternative in the tools of modern finance widely used
by companies to transfer risk to someone else. A firm that pays workers in dollars and sells
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products in euros can easily contract to eliminate the risk of exchange-rate swings. "Risk is now
a separable dimension of management decisions," Mr. Merton said at last week's gathering of
Nobel laureates in Lindau, Germany.
SO WHY NOT let Wall Street take risk off ordinary folks' shoulders, too? Think of it as better
living through derivatives.
Banding together to spread risk isn't new. Fire insurance allows homeowners to spread the risk of
calamity. But while Wall Street keeps marketing new ways for business to shed risk, it seems to
focus on new ways for households to assume risk and play at the rich folks' casino.
That's not what people need, Mr. Merton argues. Retirees who fear they may outlive their
savings need low-cost annuities, the kind that guarantee an inflation-adjusted monthly stipend no
matter how long one lives, how bad the markets, how severe inflation. Let big financial houses
and deep-pocketed investors take those risks. Such annuities are available, but don't seem
popular with either consumers or producers of financial services.
More-sophisticated products may spur demand, he suggests. One insurer, he says, is
contemplating discounts to people who buy both an annuity and long-term-care insurance -- on
the theory that people who use one (that is, go into a nursing home at age 75) aren't likely to use
the other for long (that is, collect on their annuity to age 100).
He hails a year-old plan created by TIAA-CREF, the finance house begun to invest professors'
retirement savings, that lets parents shed the risk of skyrocketing college tuition. Put up roughly
90% of the sticker price today, and 242 participating colleges will give you a certificate worth
one year's tuition in 2014 (if your kid is admitted).
The colleges take the risk of stock-market gyrations and the risk that tuition will rise even more
rapidly than projected. It's a hard sell. Only about 2,000 people -- and $30 million -- have signed
up. "It is difficult to explain to somebody what their return is," says TIAA-CREF's Richard
Calvario.
THE SPECTACULAR implosion of Long Term Capital Management, the hedge fund that Mr.
Merton helped found, is an obvious warning that this isn't as foolproof as evangelists of finance
make it sound. Mr. Merton won't talk about LTCM on the record, but likens derivatives to
antilock-braking systems on cars. "They could make us safer," he says, "but we could also use
them to drive faster." We don't shun ABS brakes, he argues, so why shun derivatives.
Another Nobel laureate economist who listened to Mr. Merton's pitch, William Sharpe of
Stanford University, is intrigued, but as yet unconvinced. He wonders if the cost that big
financial firms will charge for absorbing risks will exceed the benefits for middle-class families
who shed them.
"Making things simpler for consumers introduces complexity for producers," Mr. Merton
acknowledges. It would be simpler for auto makers to make one-door cars in a single color, and
force consumers to adjust, he says.
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But they don't. Neither should companies that peddle mutual funds, insurance, college-savings
plans and annuities in the "ownership society."