Buffett salvo revives fears of derivatives doom
Reuters, 03.04.2003, 6:27 PM ET
By Eric Burroughs and Dan WiIchins
NEW YORK, March 4 (Reuters) - Warren Buffett's broadside against the opaque world of derivatives provided a prominent voice to critics who fear these securities could bring Armageddon to the global financial system and have crowed for regulation over the vast market.
Buffett branded derivatives as "financial weapons of mass destruction" in a letter to Berkshire Hathaway shareholders, but the colossal $127 trillion market has garnered praise from regulators like Federal Reserve Chairman Alan Greenspan for reducing risks.
By widely spreading the risks from a stock market plunge and massive bankruptcies like WorldCom and Enron, the little-understood market is seen as having helped soften the blow from the late-1990s bubble exploding.
While the world's second wealthiest man and chairman of Berkshire is not above using derivatives for the company's portfolio, Buffett gravely warned the financial system was at "mega-catastrophic risk" from the intricate links derivatives weave between global banks, insurance companies and the like.
The likelihood of such a "domino effect" was cast in stark light by the near collapse of the huge hedge fund Long-Term Capital Management, whose bad trades threatened to bring the financial system to its knees in lat~1998. That prompted the Fed to help organize a rescue and cut interest rates to restore confidence.
The "Oracle from Omaha," whose investment insights are closely watched around the world, brings high-profile support to those demanding the derivatives not traded on exchanges come under the microscope of regulatory oversight -- something powerful banks have fought against tooth and nail.
“These derivatives do pose a danger to our financial markets and the economy as a whole. They need special attention," said Randall Dodd, a former economist at the Commodity Futures Trading Commission and head of the Financial Markets Forum in Washington who has been an outspoken advocate of regulation.
Derivatives are contracts based on underlying cash securities or things, ranging the gamut from interest rates and currencies to energy and weather. They allow investors to both buy protection against various risks and also make big leveraged bets.
Some derivatives like futures for oil, cattle and U.S. Treasuries are traded on exchanges and regulated. But the vast majority of derivatives are traded directly between parties in the over-the-counter market.
Because of their complexity, derivatives have spooked some commentators who talk about them as the toxic concoction of nefarious bankers that could bring today's entwined global markets crashing down.
Buffett bemoaned how hard it is to find out the derivatives risks banks have in their reports, and fretted about the concentration of derivatives among major banks.
"These problems have been brewing for years, and we've been lucky to dodge the bullets so far," said Frank Partnoy, author of "FIASCO," an autobiography of his experience as a derivatives salesman on Wall Street, and now a professor at the University of San Diego School of Law.
"He's right on target, and is in a perfect position to know and comment on these things," he said about Buffett. "There needs to be more disclosure here, so investors can know about the derivatives positions of companies they invest in," he said.
DODGING REGULATION
Even Enron's demise and manipulation of electricity prices in California has yet to stir a groundswell of political support for regulation -- almost a year and a half later. California Senator Dianne Feinstein has said she will reintroduce legislation to regulate trading of energy and metals derivatives, after failing to get support last year.
Derivatives backers, particularly the International Swaps and Derivatives Association (ISDA), the industry's trade group, contend the contracts are used primarily to disperse risks widely and by doing so cut down the odds of the financial system suffering from a major shock.
The fact Enron's collapse did not cause major disruptions, even with its huge derivatives portfolio, was a testament to the market's maturity -- even as it roiled energy derivative markets that have yet to fully recover.
"The evidence from our academic colleagues is that the effect of shocks to the market is smaller if there are derivatives in the market, because the risk is spread among more parties," said Charles Smithson, a partner at Rutter Associates, a risk management consulting company in New York.
And following the crises that have hit, from LTCM and Enron, major banks and users of derivatives have learned their lessons and become more savvy at gauging potential risks from other counterparties in derivative contracts.
"Firms have gotten pretty sophisticated about protecting against exposures," said Robert Pickel, chief executive of ISDA.
WINDING DOWN
Buffett's own charges come from frustrations in winding down the portfolio of a derivatives boutique, General Re Securities, he bought along with reinsuer General Re in 2000 for Berkshire Hathaway Inc. Buffett said the process would take a "great many years."
"The reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit," he said in his annual letter to investors, first published in Fortune.
Ironically, Buffett was happy to have General Re Securities. In a press release in May 2000, General Re quoted Buffett as saying he was 'unequivocally" against selling or spinning off the derivatives unit.
So far Congress and various administrations have shown little inclination to regulate derivatives. And Fed chief Greenspan has been one of the most outspoken in defending the market from regulation.
"Regulation is not only unnecessary in these markets, it is potentially damaging, because regulation presupposes disclosure and forced disclosure of proprietary information can undercut innovations in financial markets," he said in a speech last year on regulation, innovation and wealth creation.
But as Dodd responded, "Alan Greenspan has never seen a government regulation he's liked in his life."
Copyright 2003, Reuters News Service