Financial Weapons Of Mass Destruction

Financial Weapons Of Mass Destruction

photo credit: laffy4k

New York Times called the possibility of an AIG liquidation “as close to an extinction-level event as the financial markets have seen since the Great Depression.”

We keep hearing that the current financial mess is because of sub-prime mortgages and that Canada has nothing to worry about. Sub-prime mortages are part of the crisis - up to 2 trillion dollars are at stake.

But derivatives dwarf the sub-prime problem.

When Clinton introduced deregulation in 1993 it allowed 450 trillion in derivatives to be created.

The explosion of the derivatives market has been unbelievable—dwarfing the actual market from which they are derived. The variety and complexity of these instruments is so extreme that usually people just shake their heads and walk away.

But at root, derivatives are very, very simple conceptual instruments.It’s what the market has done with them that is frightening.

And, Canada’s banks and financial companies are in on this game.

Warren Buffet predicted this crisis over 5 years ago…

Berkshire Hathaway Annual Report 12/31/2002

Warren Buffet on derivatives:

We view them as time bombs, both for the parties that deal in them and the economic system.

Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by such as interest rates, stock prices or currency values.

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 on the number of twins to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.

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”. 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.

Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, 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.

… 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.

… 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 other.

The troubles of one could quickly infect the others.

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.

… 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 megacatastrophe 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.