Are Derivatives Financial "Weapons Of Mass Destruction"?

by Helen Simon,CFP® (Contact Author | Biography)

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Filed Under: Bonds, Derivatives, Insurance, Options, Warren Buffett
In 1988, the then-Fed chairman Alan Greenspan stated, "What many critics of equityderivatives fail to
realize is that the markets for these instruments have become so large not because of slick sales
campaigns, but because they are providing economic value to their users."

But not everyone had a good feeling about this financial instrument. In his 2002 Berkshire
Hathaway (NYSE: BK) letter to shareholders, company chairman and CEO Warren Buffettexpressed his
concern with derivatives, referring to them as "weapons of mass destruction," a term popularized by
George W. Bush to describe nuclear arms. How is it possible that two wise, well-respected financial gurus
could have such differing opinions? Unfortunately, this is not a question that has a simple answer. (For
background reading on derivatives, see Are Derivatives Safe For Retail Investors?)

The Story Behind Buffett's Perspective

Buffett's perspective may well have been driven by his own experience with some derivative positions he
inherited as a result of Berkshire's $22 billion purchase of General Reinsurance Corporation in 1998 (the
largest U.S. property and casualty reinsurer at the time). The General Reinsurance purchase also
included 82% of the stock of Cologne Reinsurance, the oldest reinsurer in the world. This acquisition
represented reinsurance and operations of all lines of insurance in 124 countries. It was a seemingly
excellent strategic endeavor in consideration of globalization, and was heralded as the next frontier.

General Reinsurance Securities, a subsidiary of General Reinsurance initiated in 1990, was a derivatives
dealer tied to global financial markets. Unfortunately, this relationship had unpredictable
consequences. Buffett wanted to sell the subsidiary, but he could not find an
agreeable counterparty (buyer). So, he decided to close it, which was easier said than done, as this
decision required him to unwind the subsidiary's derivative positions. He likens this unwinding task to
entering hell, stating that derivatives positions were "easy to enter and almost impossible to exit." As a
result, General Reinsurance recorded a $173 million pretax loss in 2002.

In Buffett's 2002 letter to shareholders, he describes derivatives as "time bombs" for all parties
involved. He goes on to temper this statement by saying that this generalization might not be judicious
because the range of derivatives is so great. His derogatory comments about the specific derivatives he
inherited appear to be directed toward those that create vast leverage and are involved in counterparty
risk. (For related reading, see Hedge Fund Failures Illuminate Leverage Pitfalls and Corporate Use Of
Derivatives For Hedging.)

Derivatives Explained
In the broadest sense, derivatives are any financial contracts that derive their value from other underlying
assets. However, this brief definition does not really give a true idea of what a derivative is or what it could
be. In reality, these instruments run the gamut from the simplestput option purchased to hedge one's
personal stock position, to the most sophisticated, dynamic, financially
engineered, swapped, strangled and straddled package of bits and pieces. The derivatives market is
large (about $516 trillion in 2008) and eperienced very rapid growth through the late '90s and early 2000s.
As such, it is a grave mistake to simply leave the definition of a derivative as a financial weapon of mass
destruction without expounding on what makes some derivatives fall into this category, while others are
as simple as buying homeowner's insurance. One should take heed of former SEC chairman Arthur
Leavitt's 1995 caveat that "derivates are something like electricity; dangerous if mishandled, but bearing
the potential to do good."

Buffett's Prophecy
Since Buffett first referred to derivatives as "financial weapons of mass destruction" in reference to
derivatives, the potential derivatives bubble has grown from an estimated $100 trillion to $516 trillion
dollars in 2008, according to the most recent survey by the Bank of International Settlements. In addition,
2008 was marked by Société Générale's Jerome Kerviel's orchestration of the largest bank fraud in world
history via derivatives trading (a £3.6 billion loss). This makes previous rogue trader incidences pale in
comparison:
• Nick Leeson at Barings Bank in 1995 (a £791 million loss and bankruptcy for his employer)
• National Westminster Bank PLC in 1997 (a $125 million loss)
• John Rusniak at Allied Irish Bank in 2002 (a $691 million loss)
• David Bullen and three other traders at National Australia Bank in 2004 (a $360 million loss)
Even in other derivatives arenas, the stakes appear to be increasing at an equally alarming rate. For
example, Orange County, California lost $1.7 billion in 1994 from debt and derivatives used to expand its
investment fund and Long Term Capital Management lost $5 billion in 1998. In addition, the subprime
credit meltdown of 2007 is estimated in the hundreds of billions of dollars. (For more insight,
read Massive Hedge Fund Failures.)

Financial Trickery Easy To Do

Buffett references the dangers of derivative reporting on and off the balance sheet. Mark-to-
market accounting is a legal form of accounting for a venture involved in buying and selling securities in
accordance with U.S. Internal Revenue Code Section 475.Under mark-to-market accounting, an asset's
entire present and future discounted streams of net cash flows are considered a credit on the balance
sheet. This accounting method was one of the many things that contributed to the Enron scandal.

Many people attribute the Enron scandal entirely to cooking the books or accounting fraud. In fact,
marking to the market or "marking to the myth", as Buffett so aptly christened it, also plays an important
role in the Enron story. Mark-to-market accounting is not illegal, but it can be dangerous. (To gain an
understanding of this particular weapon, put aside a few hours to watch "The Smartest Guys In The
Room", a movie about the Enron scandal.)

Buffett suggests that many types of derivatives can generate reported earnings that are frequently
outrageously overstated. This occurs because their future values are based on estimates; this is
problematic because it is human nature to be optimistic about future events. In addition, error may also lie
in the fact that someone's compensation might be based on those rosy projections, which brings issues of
motives and greed into play.

The Unwinding of General Reinsurance

Buffet updated his shareholders about the General Reinsurance situation in his 2003, 2004 and 2005
letters to BK shareholders. In his 2006 letter, Buffett states that he is happy to report that this will be his
last discussion of the General Reinsurance derivatives mishap, which as of 2008, had cost Berkshire
$409 million in cumulative pretax losses to date. In his 2007 letter, Buffett indicates that Berkshire has 94
derivative contracts that he manages, along with only a few remaining positions from General
Reinsurance. These include 54 contracts that require BK to make payments if certain high-yield
bonds default, and a second category of short European put options on four stock indexes (the S&P 500
and three foreign indexes). Buffett stresses that with all of these derivative positions, there is no
counterparty risk and the accounting of profits and losses are transparent. He refers to derivatives being
valuable on a large scale to facilitate certain investment strategies.

Does Anyone Know This Rabbit Hole?

Did Buffett, one of the world's richest men and an investing icon, foresee a future that others chose to
ignore? Say what you will about Buffett's folksy, simple attitude toward finance, the bottom line is that he
has outperformed nearly every investor alive while growing his company into one of the world's largest
corporations. In his March 2007 Condé Nast Portfolio article, Jesse Eisinger poses the question, "If
Warren Buffett can't figure out derivatives, can anybody?" Markets have become vastly more complex
over just the last 100 years and are increasingly linked in ways that regulators and even folks of the
highest financial caliber struggle to understand. Treasury Secretary Henry Paulson confirmed this
sentiment in hisMarch 14, 2008, televised statement on liquidity issues at Bear Stearns. The binding
threads that run throughout these vast financial galaxies are derivatives, and the brightest minds on Wall
Street worry about how they work - especially as stock markets around the world become more
unpredictable and complex. (For related reading, see Dissecting The Bear Stearns Hedge Fund
Collapse.)

Parting Thoughts
Buffett's 2002 description of derivatives as financial weapons of mass destruction may have been more of
a prophecy than anyone could have realized at the time. The key here is that there are many different
types of derivatives; they aren't all equally destructive. Therefore, it is extremely important to understand
exactly what one is dealing with before an intelligent assessment can be made.

by Helen Simon,CFP® (Contact Author | Biography)

Helen K. Simon, CFP®, DBA, is on the faculty of Florida International University in Miami, where she
teaches classes in financial management, risk management and international finance. She is also the
president of Personal Business Management Services, LLC, located in Fort Lauderdale, Florida. Simon
has resided in South Florida since 1974 and has nearly 20 years of professional experience in the
financial services and investment field.