"Charlie (Munger, Buffett’s chief lieutenant) 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, let me retreat to explaining derivatives. 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. Derivatives contracts are of varying duration (running sometimes to 20 or more years) and their value is often tied to several variables.

Unless the contracts are collateralised 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 newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that we didn’t want, judging it dangerous. We failed 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. In fact, the reinsurance and derivatives businesses are similar: like Hell, both are easy to enter and almost impossible to exit. Another commonality is that both generate reported earnings that are often wildly overstated. That’s because they are 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 on “earnings” calculated by mark-to-market accounting. But often there is no real market and “mark-to-model” is utilised. This substitution can bring on large-scale mischief. Of course, both internal and outside auditors review the numbers, but that’s no easy job. 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. The valuation problem is far from academic. Some huge-scale 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.

The marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader eyeing a multimillion-dollar bonus or the CEO wanting 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.

Derivatives 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. It can all become a spiral that can lead to a corporate meltdown.

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. History teaches us that a crisis often causes problems to correlate in a manner undreamt 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. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or 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. On a micro level, this is often true. Indeed, I sometimes engage in large-scale derivatives transactions to facilitate certain investment strategies.

However, 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 dealers, who in addition trade extensively with one another. The troubles of one could quickly infect the others.

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. Fed officials later acknowledged that, had they not intervened, the outstanding trades of LTCM could well have posed a serious threat to the stability of American markets. This affair, though it paralysed many parts of the fixed-income market for weeks, was far from a worst-case scenario.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

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