Tuesday, September 23, 2008

financial weapons of mass destruction

Think the current financial meltdown due to wildly-reckless, unregulated speculative financial activity wasn’t foreseeable?

Here’s my hero (and Obama advisor) Warren Buffett over five years ago from the
2002 Berkshire Hathaway shareholders letter:


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.

Having delivered that thought, which I’ll get back to, let me retreat to explaining derivatives, though the explanation must be general because the word covers an extraordinarily wide range of financial contracts.

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.

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.

The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.

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, however, and are now terminating it.

But closing down a derivatives business is easier said than done. It will be a great many years before we are totally out of this operation (though we reduce our exposure daily). In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability.

Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market
accounting. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

Of course, both internal and outside auditors review the numbers, but that’s no easy job. For example, General Re Securities at yearend (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. Valuing a portfolio like
that, expert auditors could easily and honestly have widely varying opinions.

The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.”

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the 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.

Another problem about derivatives is that they 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. Imagine, then, that
a company is downgraded because of general adversity and that its derivatives
instantly kick in with their requirement, imposing an unexpected and enormous
demand for cash collateral on the company. The need to meet this demand can
then throw the company into a liquidity crisis that may, in some cases, trigger
still more downgrades. It all becomes a spiral that can lead to a corporate

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a
liquidation mode for nearly a year.) 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 crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

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.

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.

Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets.
In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the
purchase of a stock while Party B, without putting up any capital, agrees that at a
future date it will receive any gain or pay any loss that the bank realizes.

Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved
with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

(That’s why I am a shareholder of Berkshire Hathaway.)

Perspective on the
size of the problem with credit default swaps (just one kind of derivative):

[Click on image to enlarge.]

The current estimate is more in the $60 trillion to $70 trillion range.

By comparison, US gross domestic product is roughly $13.5 trillion. In other words, the credit default swap market is roughly FOUR TIMES the entire US GDP. It is equal to or larger than the ENTIRE WORLD GDP.

Do you think $700,000,000,000.00 is going to solve the problems of our financial system?


Aric said...

A wonderful piece of writing. I hope Buffet is somehow involved in advising an Obama presidency. The more involvement the better.

Gilmoure said...

Just saw that Buffet is investing in Goldman Sachs. Looks like that may bring some confidence back to the market. I still wonder how the $7B bailout will go through. I mean, something has to go through and it looks like congress is pushing for a pay as you go rather than a large lump sum. 'Course, Paulson's digging in his heels over this and oversight. Interesting times we live in.

natureboy said...

Sept. 24 (Bloomberg) -- Billionaire Warren Buffett, calling turmoil in the markets an ``economic Pearl Harbor,'' said his $5 billion investment in Goldman Sachs Group Inc. is an endorsement of the Treasury's $700 billion bank rescue plan.

Your hero is, as usual, talking up his book. Time for a new hero?

polit2k said...

Crisis speak: A new and even more absurd lexicon
Turbulent times call for eloquence, obfuscation, literary skill and, sometimes, a knack for being creative with the truth. In the past couple of weeks, various CEOs and spokesmen have excelled themselves, building on that old genre of “crisis speak” (”things are not necessarily going in our favour” etc.) to develop an even more - er, oblique - set of phrases to deal with these times.
Here are some choice examples, drawn from FT Alphaville’s expert critics commenters and the letters column of the FT.
From Aidan Kennedy of London SW11, and who believes “it might be time for the credit crunch generation to develop its own lexicon”:
- To AIG disgracefully: to casually take out an enormous loan.
- To applegarth: to let ambition get the better of you.
- To fuld: to prevaricate fatally.
- To greenspan: to conveniently forget your errors.
- To paulson: to screw your former competitor.
- To thain: to get out while the going’s good.
- To bernanke: to suffer from recurring nausea. For example, “My stomach’s a bit bernanke this morning.”
Finally, a proverb: “Beware of Greeks bearing stearns” which means you may be forced to gazump yourself.
From WilliamBanzai7, who has quite a way with words:
JOHN McCAIN Meets Wall Street - The following Fighter Pilot JARGON glossary is provided in order to expedite discussions with John McCain concerning TARP (aka Clusterf—)
- Agent Orange: A toxic equity tranche
- Body Count: Number of bankers fired
- E&E: Escape and evasion tactics: Often applied by Wall Street CEOs
- Hootch: What investors smoke before they visit Bear Stearns and Lehman
- ****: What you will find in Lehman and AIG’s financial footnotes
- Level 3 Asset: Covert assets
- Delta: A Wall Street hedging strategy
- Oversight: What Congress must do: Excuse us for the oversight.
- AAA: Anti Aircraft Artillery/ also Rating Agency Jargon
- AVRN: Already Very Rough Numbers
- Golden Parachute: Every pilot and CEO must have one
- Tailhook: The contingent liability payable under a CDS
- SAM: S—ty asset marks
- Bandits: Wall Street Bankers
- Jesus Bolt: The nut that holds everything together
- Gigahertz and Nanoseconds: Highly technical, detailed, and hard to understand (”It’s getting down to gigahertz and nanoseconds.”)
- Lost the Bubble: Got confused or forgot what was happening.
- Loud Handle: Lever or grip that fires ejection seat. Often used by Wall Street CEOs
- Selling short: What the US government does to its Armed Forces
- Smoking Hole: A bottomless crash site. Toxic asset mark downs.
- TOP Gun: Rainmaker
- Tunneling: What hedgefund shorts do to financial reports
- Up on the Governor: When someone is about to have a tantrum (term comes from the device that keeps the engine from overspeeding).
- Up to Speed, or Up to Snuff: To understand or to know what’s going on.
- Unknown Unknowns: The derivatives market


williambanzai7 said...


For use at the World Financial Crisis Summit

By WilliamBanzai7

Absquatulate- To disappear or get out of Dodge City

Alamos- The fall of Lehman

Ace-high ~ Highest rating agency score.

According to Hoyle ~ Regulatory requirements. Hoyle is the card playing dictionary.

A hog-killin' time ~A market bubble

Ambush- What "W" says to himself constantly "I am Bush"

A lick and a promise ~Over the counter trade

Bad medicine-Bad market news

Big hat no cattle- Paul Volker and Alan Greenspan

At sea ~ at a loss, not comprehending. "When it comes to finance, I am at sea."

Bail out-Bail out

Bandito- A sort seller

Bang-up ~ first rate. Similar to "heck of a" "The SEC sure did a bang-up job."

Bartenders- Rating agencies

Bank heist- Robbed by your banker

Bear sign ~ cowboy term for financial trouble.

Beat the devil around the stump ~ to evade responsibility or a difficult task. "Quit beatin' the devil around the stump and bail that sucker out."

Bend an elbow ~Forcing a bank to accept bailout money

Bender ~ drunk. "Wall Street's off on another bender."

Best bib and tucker ~ your best pinstripes.

Big gun ~ A Central Banker "He's one of the Feds big buns."

Bilk ~ Fraudulent behavior

Bone orchard ~ Cratered deals.

Boot Hill- The United States Bankruptcy Court Southern District New York

Bunko artist ~ Quantitative engineer

Bushwack- Selling repos or getting votes

Buzzard food- Level 3 asset

By hook or crook ~ to do any way possible.

Calaboose ~ jail.

Catawamptiously-Thoroughly, utterly. Catawamptiously insolvent!

Cattle Baron-Wall street CEO

Cattle Kate-Female investment banker

Chucklehead-An AIG executive

Chinaman- One who is loaded with capital

Chisel, chiseler ~ to cheat or swindle, a cheater.

Clean his/your plow ~ A good or bad trade

Coffee boiler ~ Jr Analyst

Copper a bet ~ Hedging or being prepared against loss. "I'm just coppering my position."

Come a cropper ~ come to ruin, fail, or fall heavily. "He had big plans to get rich, but it all come a cropper, when the bank failed."

Croaker ~ pessimist, doomsayer. "Nouriel Roubini is just an old croaker."

Crowbait ~ derogatory term for a poor-quality asset class.

Custer- Dick Fuld

Difficulty ~ euphimism for trouble, often the shootin' or otherwise violent kind. "He had to leave Wall Street on account of a difficulty with the SEC."

Deadbeat ~ Unemployed banker.

Dinero ~ from the Spanish, a word for money.

Don't care a continental ~ Don't give a damn about the EURO.

Down on ~ opposed to. "He is really down on cheap leverage."

Dragged out ~ fatigued, worn out.

Dreadful ~ very. "Oh, these CDOs are dreadfully lucrative."

Dry gulch ~ Short seller ambush.

Dude ~ an Easterner, or anyone in up-scale town clothes, rather than plain range-riding or work clothes.

Dude ranch- Bond conference

Eucher, euchred ~ to out-smart someone, to be outwitted or suckered into something. "We sure euchered that pension manager"

Fandango ~ from the Spanish, a big deal closing party with lots of dancing and excitement.

F Troop- The United States Securities Exchange Commission

Federales-Washington regulators

Fetch ~ bring, give. "Fetch me my blackberry."

Flannel mouth ~ an overly smooth or fancy talker, especially politicians or derivative salesmen. "I swear that banker is a flannel-mouthed liar."

Flush ~ prosperous, rich.

Fork over ~ pay out.

Four-flusher ~ a cheat, swindler, liar.

Fools gold- Synthetic CDO

Friendlies- Gullible investors

Full as a tick ~ Irrationally exuberant.

Fuss ~ disturbance. "They had a little fuss at the FED."

Get it in the neck ~ get cheated, misled, bamboozled. Goldman gave it to AIG in the neck.

Get the mitten ~ to be rejected by a potential investor. "Looks like the Koreans gave poor Fuld the mitten."

Ghost Rider- Bull market investor

Go through the mill ~ gain trading experience. (Often the hard way.)

Gold Country- The Gulf States

The Good, the Bad and the Ugly- Goldman, Lehman, Bear Stearns

Halleluja Trail- AMTRAK train to Washington DC

Hired Gun- Wall Street lawyer

Hole in the Wall Gang-Private equity fund managers

Hoosegow ~ jail.

Hot as a whorehouse on nickel night ~ volatile market

Is that a bluff, or do you mean it for real play? ~ Are you serious?

The Heckowy Tribe-AIG "Where the heck ah we?"

Hostile Indians-Mumbai short sellers

Jig is up ~ scheme/game is over, exposed. Loss of all market confidence

The "Judge"- Alan Greenspan

Let slide/ let drive/ let fly ~ go ahead, let go. "If you think you want trouble, then let fly."

Light (or lighting) a shuck ~ to get the hell out of here in a hurry. "I'm lightin' a shuck for Bermuda."

Loot- Cash bonuses

Lynch Mob- Angry shareholders.

Mudsill ~ low-life, thoroughly disreputable banker.

Nailed to the counter ~ proven a lie. That road show presentation is nailed to the counter.

Necktie social- Hanging someone with rumors

Nucular weapons-CDSs

OK Coral- NY Federal Reserve Bank

Odd stick ~ eccentric person. "Judge Greenspan sure is an odd stick."

Of the first water ~ first class. "It's a security of the first water."

Outlaw- Errant banker

Pardon my French- ____________

Pass the buck ~ What Wall Street CEOs do.

Pay through the nose ~ Settle of a credit default swap.

Peter out ~ Cheap market rallies peter out.

Pilgrim- Naive investor

Pistolero- Hedge fund guru.

Play to the gallery ~ to show off. "That's just how he is, always has to play to the gallery."

Plunder ~ personal belongings. "Pack your plunder, Joe, we're headin' for Dubai."

Posse- An underwriting sydicate

Powerful ~ very. "He's a powerful rich man."

Pull in your horns ~ back off a trading strategy.

Quick silver- Toxic equity tranche of synthetic CDO

Rake and scrape- Asset recovery in Chapter 11

Road agent- Distressed debt investor

Rodeo- A world market summit

Rodeo Clown- W

Round up- Looking for white knight investors

Rich ~ amusing, funny, improbable. "Oh, that's a rich pitch!"

Ride shank's mare ~ to be laid off.

Riding shotgun-What Bernanke does for Paulson

Rob the bank- Borrow from the Fed

Roostered ~ drunk. "Looks like those Wall Street boys are all in there gettin' all roostered up."

Russling- Making a market

Russler- market maker

Scatter Gun- The TARP legislation

Seeing the elephant ~ Going to Wall Street or the City of London, where all the action is.

Sell your saddle- Resign from office

Scalping- Marking to market

Scoop in ~ trick, entice, inveigle. "He got scooped into a credit swap and lost his shirt."

Scuttlebutt ~ market rumors.

Shave tail ~ a green, inexperienced hedge fund trader.

Shoddy ~ poor quality paper.

Shoot, Luke, or give up the gun ~ poop or get off the pot, do it or quit talking about it. Come on Hank, shoot luke or give up the gun!

Shoot one's mouth off ~ talk nonsense, untruth. "Wilumstead was shootin' his mouth off and Paulson gave him a black eye."

Shove the queer ~ to pass securitized assets (CDOs).

Simon pure ~ the real thing, a genuine fact. "This market bust is Simon pure."

Skedaddle ~ run like hell.

Smoke the Pipe- Listen to a lecture on self regulation and free markets

Snake oil salesman- Seasoned investment banker

Stage Coach- Limo service

Stampede-A market run

Stand the gaff ~ take punishment in good spirit. "Wall Street bankers can't really stand the gaff."

Stumped ~ confused. I'm stumped!

Sun up-Market open

Sun down-Market close

Superintend ~ oversee, supervise. "He just likes to superintend everything."

Take French leave ~ to desert, sneak off without permission.

Take the rag off ~ surpass, beat all. "Well, good old Warren knows how to take the rag off the bush."

The Old States ~ back East.

The whole kit and caboodle ~ the entire company.

The Unforgiven- Enron

Throw up the sponge ~ File Chapter 11 petition

Tombstone-An announcement

The Undertaker- Harvey Miller- Undisputed dean of the bankruptcy bar, currently represents Lehman

Up the spout ~ gone to waste/ruin. The bank's capital went up the spout.

Wake up/Woke up the wrong passenger ~ to trouble or anger an activist investor.

Wampum- Money

The Wild Bunch-Hedge fund managers

Wind up ~ settle. "Let's wind up this business and go home."

Wild West- Wall Street

Wyatt Erp- Andrew Cuomo

Yammerin- Talking to investors and taxpayers