Derivatives are time bombs: Buffett

In a rare break from tradition, Warren Buffett on Monday released parts of his annual letter to shareholders on the Web site of In a rare break from tradition, Warren Buffett on Monday released parts of his annual letter to shareholders on the Web site of Fortune..

In this year's letter, Buffett writes about the difficulties of exiting the derivatives business he inherited in the purchase of General Re.

He also concludes that the explosion in derivatives contracts may have created serious systemic risks.

"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," says the letter.

"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," says Buffett.

"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."

"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," Buffett writes.

He goes on to explain why Berkshire Hathaway is exiting the derivatives business, which came their way through the 1998 acquisition of Gen Re.

"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."

"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."

"Unlike the Fed, which now insulates the strong from the troubles of the weak, 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."

"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."

"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 per cent 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."

"Charlie and I believe," Buffett writes," that 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."

Agencies