---

In the five years since Warren Buffet’s warning about long term financial derivatives contracts the volume of such derivatives has increase five times from $100 trillion to $516 trillion. This according to BIS via Paul B. Farrell of CBS Marketwatch.com, implies “a massive new derivatives bubble is driving the domestic and global economies, a bubble that continues growing today parallel with the subprime-credit meltdown triggering a bear-recession.”

The article, Derivatives the new 'ticking bomb’, quotes Warren Buffet from his annual letter to Berkshire Hathaway shareholders in 2002. The letter itself (like all of the Berkshire Hathaway reports) is worth a read. Here are some of the highlights:

Charlie 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.

As you can see Buffet’s concerns were with un-collateralized derivatives, especially long term contracts.

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.

Also his explanation of derivatives is excellent:

Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction – with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration (running sometimes to 20 or more years) and their value is often tied to several variables.

So we know that Buffet is warning of a specific kind of derivatives, not the futures and options we typically think of when discussing derivatives.

While the thought of risky un-collateralized long term derivative contracts might not make you quiver in your boots, implications of even a small portion of those contracts going bad is the real specter that has people scared. Look at the current Sub-prime fiasco as an example. Only a small portion of those loans have actually gone bad, but it’s enough to destabilize the whole financial industry and possibly cause a bear market.

Let’s not forget the LTCM (Long Term Capital Management) mess that “nearly brought down the world's banking system.” Speaking of the world’s banking system, Bill Gross of Pimco thinks that “what we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August."

What does all this mean to me the “average” investor? I’m not really sure. On the one hand there is almost nothing you can do about it yourself. You can try to find secure investments if you think that these derivatives are a real problem.

My main concern is that I’m looking to put my portfolio on autopilot with low cost index funds. Knowing that that Wall Street really screws up every once in awhile should I instead look to maximize those opportunities and scoop up cheap companies Graham style? What’s interesting to me is during my adult life every time there’s been a major financial problem, (internet bubble, housing bubble, sub-prime mess) it’s been predicted well in advance.

So again this raises the question, do I accept market returns (and the market’s mistakes) or do I make an effort to research and buy individual companies at good prices. At this point, I don’t know. I’m still leaning towards index funds as I don’t have the time to research companies; however looming financial disasters like these have a silver lining of opportunity.

The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger – but recognize the opportunity. — John F. Kennedy

Tags    Bill Gross    Derivatives    Investing    Warren Buffet

Related Posts

• What is a Hedge Fund?
• Back To Basics
• Warren Buffet On the Credit Crises
• Americans Are Mad About Sale of Budweiser
• Searching For an Investment Mentor

Comments