March 5, 2003
Buffett Rekindles Derivatives Debate
On Monday Fortune published a sneak preview of Berkshire Hathaway’s Annual report. Buffett was in fine form:
“we still find very few (stocks) that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge.”
Buffett goes on to talk about his current interest in junk bonds -- noting “we expect that we will have occasional large losses in junk issues” -- and he offers a thoroughly entertaining and informative viewpoint on derivatives:
“In our view derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Fortune Berkshire Hathaway
Buffett Is All Business
To begin with, Buffett’s warning on derivatives is nothing new – derivatives have been synonymous with the phrase ‘time bomb’ ever since the blow-up and Fed orchestrated bailout of LTCM. However what is surprising is that Buffett did not mention many of the benefits of derivatives. Rather, Buffett suggested that some derivatives are created by ‘madmen’, he compared entering into a derivatives contract to hell (‘easy to enter and almost impossible to exit’), and he suggested that marking errors are made on purpose by unseemly traders and CEOs. Remember, Buffett is not some crackpot, but arguably the greatest investor of all time, and one of the most knowledgeable and honest CEO’s in the business.
Why didn’t Buffett sugar coat his comments on derivatives like every other CEO? Because he does not want to be in the derivatives business.
“When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie and I didn't want, judging it to be dangerous. We failed in our attempts to sell the operation and are now terminating it…General Re Securities at year-end (after ten months of winding down its operation) had 14,384 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity…At Gen Re Securities, we still have $6.5 billion of receivables, though we've been in a liquidation mode for nearly a year.”
The BIG Lie
Many companies tell shareholders that they use derivatives to help avoid exposure risks (risks to currency fluctuations, interest rate movements, volatile commodity prices, etc.) However, what many companies do not tell shareholders is that the derivatives they use to hedge against exposure risks can sometimes create risks that previously did not exist. For example, to hedge against a potential drop in the price of gold a producer may write call options (the producer keeps the call premium if gold drops and/or the calls expired worthless.) To note: a written call option can, in theory, turn into infinite losses.
That said, some derivatives are used strictly for hedging purposes. For example, Bema Gold states that ‘we would consider buying put options in the future to hedge against the risk of a falling gold price.’ The purchase of a put option, unlike the writing of a call option, is a hedge. Why? Because a put option -- like purchasing fire, theft, or terrorism insurance -- is immediately recorded as an expense and this expense (or cost) can not rise or fall (until it expires).
In short, the big lie is when a company argues that derivatives are being used for hedging purposes but the company continues to keep a running tab on how its hedgebook is performing. An insurance policy (or hedge) has fixed and known costs before it is purchased.
The Unregulated OTC Derivatives Business
Hedge funds, JP Morgan, Merrill, Citigroup, etc., do not use derivatives solely to hedge exposure to volatile markets. Rather, they use derivatives to generate profits.
“The majority of JPMorgan Chase’s derivatives are entered into for trading purposes”
JPM. 10-Q (3Q02).
Recognizing this, Greenspan offered some regulatory insights late last year:
“the over-the-counter derivatives market has been largely exempt from government regulation. In part, this exemption reflects the view that professionals do not require the investor protections commonly afforded to markets in which retail investors participate. But 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…” Alan Greenspan. September 25, 2002
Suffice it to say, Greenspan argues that OTC derivatives should be kept secret because -- kind of like the formula for Coke – OTC positions have been crafted with a personal touch. However, what Greenspan neglects to mention is that, due to the lack of regulation, the disclosure offered by firms is simply an interpretation from management. As Buffett says, ‘Valuing a portfolio like that (Gen Re), expert auditors could easily and honestly have widely varying opinions.”
In sum, a company can trade leveraged OTC derivatives without nearly any regulatory constraints. A company can disclose an opinion of these trades under vaguely defined GAAP. Quite frankly, is it not worth undercutting innovation just a little bit to ensure that another LTCM or Enron isn’t brewing?
Enron versus LTCM
Enron imploded because there were no safeguards; no early warning systems designed to expose dangerous derivatives and off balance sheet arrangements before they turned into multi-billion dollar nightmares. And while the argument has been made that Enron lied and manipulated their books (and this is the reason why the company blew-up), the fact is that Enron’s off balance sheet and derivatives exposure left a paper trail -- if this paper trail had been under constant scrutiny the blow-up may have never happened and/or it may not have been so massive.
Although the Enron saga may not yet be over – other merchant energy traders may go under and/or new regulations on OTC energy derivatives may be passed – it is unlikely that Enron marked the beginning of a ‘mega catastrophe’. Rather, the last time the threat of a MC loomed was with LTCM.
“Russia’s actions {devaluation of the Ruble} sparked a “flight to quality” in which investors avoided risk and sought out liquidity. As a result, risk spreads and liquidity premiums rose sharply in markets around the world. The size, persistence, and pervasiveness of the widening of risk spreads confounded the risk management models employed by LTCM and other participants. Both LTCM and other market participants suffered losses in individual markets that greatly exceeded what conventional risk models, estimated during more stable periods, suggested were probable. Moreover, the simultaneous shocks to many markets confounded expectations of relatively low correlations between market prices and revealed that global trading portfolios like LTCM’s were less well diversified than assumed. Finally, the “flight to quality” resulted in a substantial reduction in the liquidity of many markets, which, contrary to the assumptions implicit in their models, made it difficult to reduce exposures quickly without incurring further losses.”
Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management
What is interesting about LTCM is that volatile financial markets – the very thing hedge books supposedly ‘hedge’ against – ‘confounded’ expectations. Whether or not JP Morgan and others admit it or not, this is essentially what every derivatives book is: an investment, a gamble, an ‘expectation’ of what financial markets will do.
Avoiding a Mega Catastrophe
Yes, the $3.6 billion dollar bailout of LTCM was much smaller than Enron. However, why it occurred – LTCM’s risk models did not anticipate what the markets were going to do next – should have been a wake up call to regulators. Sadly, it was not.
Instead, the notional value of OTC derivatives continues to escalate and firms continue to hedge their hedgebook. The term ‘hedge their hedgebook’ means exactly what it suggests. After all, a gold producer that previously attempted to hedge their exposure to a falling price of gold by writing call options is now carrying a growing liability. Derivatives must be purchased/sold to hedge this liability.
The principle that guards the multi-trillion derivatives market has little to do with mark-to-model (‘mark-to-myth’) computations -- computations that according to Greenspan should never be disclosed -- and everything to do with the threat of mutual destruction. Remember, 14 firms bailed out LTCM because they knew if they didn’t they might be next.
“Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them…” Buffett
On this note, two final quotes from Buffett are worth considering, along with a simple question.
“the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled.”
“In banking, the recognition of a "linkage" problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But 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. That's how we conduct our reinsurance business, and it's one reason we are exiting derivatives.”
At what point does the derivatives game, which is ultimately plugged into the Federal Reserve Board’s coffers, become to big to bailout?
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