Warren Buffett's Views on Derivatives

Guys you all know how financial innovations (in terms of securitization, CDOs[Collateralize Debt Obligation], MBS [Mortgage Backed Securities] & etc) have led to present crisis. And derivatives are such instruments. The great Warren Buffet expressed his views about derivatives in 2002 only. Following are the some of his views about the derivatives:

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

2. Closing down a derivatives business is easier said than done. Like Hell, it is easy to enter and almost impossible to exit.

3. In recent years, some huge-scale frauds and near-frauds have been facilitated by Derivative trades.

4. I can assure that the marking errors in the derivatives business have not been symmetrical. They have favoured either 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.

5. Derivatives 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.

6. Company’s derivatives instantly kick in with their requirement, imposing an unexpected and an enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis which may trigger for more downgrades. It finally can lead to a corporate meltdown.

7. 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 certain problems to correlate in a manner undreamed of in more tranquil times.

8. In banking and insurance industries, firms that are fundamentally solid can become trouble simply because of the travails of other firms further down the chain. When a “Chain reaction” threat exits within an industry, it pays to minimise links of any kind. That’s how we conduct reinsurance business, and it’s one reason we are exiting derivatives.

9. Macro picture sometime carry large amount of risk. Derivatives will be concentrated in the hands of few derivative dealers. Troubles of one could quickly infect the others. These derivative instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and Governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

10. We are apprehensive about the burgeoning quantities of long term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. So, Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.