Derivatives divide financial sages Greenspan, Buffet
"Derivatives are financial weapons of mass destruction," Buffett said in his annual letter to shareholders of Berkshire Hathaway, of which he is chairman. "The dangers are now latent — but they could be lethal."
Greenspan, on the other hand, thinks the spread of derivatives has reduced rather than increased the risk that a wave of losses in some markets could trigger a financial crisis.
"These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient and resilient financial system than existed just a quarter-century ago," Greenspan said late last year.
Derivatives, essentially contracts whose value depends on an underlying asset, such as the value of a currency or a bushel of corn, have been controversial for years, especially as they have exploded in popularity.
That's because they are basically unregulated and have played a role in several financial scandals, from the fall of Barings Bank in Britain in 1995 and the collapse in 1998 of the huge New England-based hedge fund Long-Term Capital Management to the more recent demise of Enron.
The use of derivatives has grown exponentially in recent years. The total value of all unregulated derivatives is estimated to be $127 trillion — up from $3 trillion 1990. J.P. Morgan Chase is the world's largest derivatives trader, with contracts on its books totaling more than $27 trillion.
Most of those contracts are designed to offset each other, so the actual amount of bank capital at risk is supposed to be a small fraction of that amount.
Previous efforts to increase federal oversight of the derivatives market have failed, including one during the former Clinton administration when the industry, with support from Greenspan and other regulators, beat back an effort by Brooksley Born, the chief futures contracts' regulator.
Sen. Dianne Feinstein, D-Calif., has introduced a bill to regulate energy derivatives because of her belief that Enron used them to manipulate prices during the California energy crisis, but no immediate congressional action is expected.
Randall Dodd, director of the Derivatives Study Center, a Washington, D.C., think tank, said both Buffett and Greenspan are right — unregulated derivatives are essential tools, but also very risky. Dodd thinks more oversight is needed to reduce that inherent risk.
"It's a double-edged sword," he said. "Derivatives are extremely useful for risk management, but they also create a host of new risks that expose the entire economy to potential financial market disruptions."
Buffett has no problem with simpler derivatives, such as futures contracts in commodities that are traded on organized exchanges, which are regulated.
For instance, a farmer growing corn can protect himself against a drop in prices before he sells his crop by buying a futures contract that would pay off if the price fell. In essence, derivatives are used to spread the risk of loss to someone else who is willing to take it on — at a price.
Buffett's concern about more complex derivatives has increased since Berkshire Hathaway purchased General Re, a reinsurance company, with a subsidiary that is a derivatives dealer. Buffett and his partner, Charles Munger, judged that business "to be too dangerous."
Because many of the subsidiary's derivatives involve long-term commitments, "It will be a great many years before we are totally out of this operation," Buffett wrote in the letter, which was excerpted on the Fortune magazine Web site.
The full text of the letter will be available on Berkshire Hathaway's Web site tomorrow. "In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit."
Susan Phillips, dean of the George Washington University School of Business and Public Management, who is a former member of both the Federal Reserve Board and the Commodity Futures Trading Commission, said she thinks Buffett "overstated the danger" of the use of derivatives to financial markets.
"In many ways, derivatives provide stability to our markets, but they are instruments only for people who want to be in that business and have the expertise to do the valuations," Phillips said.
"We have seen a lot of volatility in markets recently, and if this had happened 15 or 20 years ago, we would have seen a lot of bank failures and failures of brokerages. The use of derivatives has helped shore up the financial system."
At least at banks, Phillips said, losses on derivatives have been very small. "That's not where they lose money. It's the old-fashioned way: bad loans," she said.