Buffett On Derivatives: 'A Fool's Game'

Warren Buffett, the billionaire investor and long-time chairman of Berkshire Hathaway Inc. (BRK.A), is a man who speaks his mind. I'm not sure whether he's always been that way, or whether it is his exceptional wealth or his age -- or both -- that emboldens him to cut through Wall Street B.S. like a hot knife and expose the bloody truth about the foibles of modern finance.

Whatever the case, his comments on derivatives, in particular, have been always been especially enlightening -- and entertaining -- because they expose this supposed risk-sharing panacea for the house of cards it has become. In Derivatives Cause 'Mass Destruction', the Wall Street Journal reports on the 'Oracle of Omaha's' latest thoughts on the subject.

Earlier Saturday, Mr. Buffet repeated his warning on the dangers of derivatives, saying that excessive borrowing by traders, investors and corporations will eventually lead to significant dislocation in the financial markets.

In fielding a question about derivatives, which he once referred to as "financial weapons of mass destruction," Mr. Buffett told shareholders that he expects derivatives and borrowing, or leverage, would inevitably end in huge losses for many financial participants.

"The introduction of derivatives has totally made any regulation of margin requirements a joke," said Mr. Buffett, referring to the U.S. government's rules limiting the amount of borrowed money an investor can apply to each trade. "I believe we may not know where exactly the danger begins and at what point it becomes a super danger. We don't know when it will end precisely, but...at some point some very unpleasant things will happen in markets."

Mr. Buffett has expressed similar bearish sentiments about derivatives in previous meetings and in his widely read annual letters to shareholders. He had first-hand experience with the difficulties of derivatives after Berkshire acquired General Re, the reinsurance company, in the late 1990s, and spent several years unwinding its derivatives portfolio at a loss to reduce the subsidiary's exposure to risk. He noted, however, that Berkshire currently has several dozen derivatives positions -- such as futures and options contracts on stock indexes and foreign currencies -- and added that "derivatives aren't evil."

Charlie Munger, Berkshire's 83-year-old vice-chairman and Mr. Buffett's droll sidekick during the six-hour annual meeting, said that the accounting of derivatives contributed to the risks they pose to the financial markets.

"The accounting being deficient enormously contributes to the risk," said Munger, lamenting that executives and shareholders were getting paid on "profits that don't exist."

Mr. Buffett noted that existing accounting conventions allow parties involved in derivative transactions to value the same contract differently, leading to an inadequate or incomplete picture of the contract's risk. "I will guarantee you, if you add up the marks on both side, they don't add up to zero," Mr. Buffett said, referring to the accounting of a single derivative contract.

Exacerbating the problem of derivatives and leverage is the short-term trading mentality and high turnover in the stock and bond markets, Mr. Buffett and Mr. Munger added. "There is an electronic herd of people around the world managing an amazing amount of money" who make decisions based on minute-by-minute stimuli, said Mr. Buffett, adding, "I think it's a fool's game."

Based on how markets have been acting lately, it would seem that most investors believe it is Mr. Buffet who is the fool. I guess we'll just have to wait and see.

Comments

[kurt walter:]

Didn't Warren do some derivatives in the past few years? It might have been something currency related. Anyway, his derivatives are the good ones, I guess. I know he was trying to buy some of Long Term Capital when it imploded a few years back. But he couldn't get it cheap enough. Everything has a price. I am sure Warren would buy derivatives if he thought they were a great deal.

2007 May 07 04:56 PM

[Johnny Bitc...:]

Yeah. We will just have to wait, and at the slightest tremors clowns like you will say you saw it coming.

How many years do you have to babble about it before you lose credibility with yourself ?

I don't doubt there are some dangers out there, and some counterparties with less backing up their deals than assumed by the other side..........but so what ?

what are we to do ? get the clowns at the SEC to make some more rules that they don't understand and can't enforce ?

Seriously, if you have some well reasoned opinions on this subject, put them forward, but there is enough junk out here on the internet that we don't need Warren Buffet cut-and-paste.

;-) john.

2007 May 10 01:25 AM

[User 164889:]

Its time to dust this article off and give credit to Buffet once again for being point on. Less than a year later Buffet's predictions have come true. Seems pretty elementary, accounting mumbo jumbo isn't cash in the bank; its just trash apparently like BearStearns value.

2008 Mar 17 04:47 PM

[Dash:]

These self proclaimed "free market" guys that can't stand the idea of the government giving a dime to a poor man for a cup of coffee are always the FIRST and loudest to scream for government help when their shell game backfires on them!
Thank you Mr. Buffet!

2008 Mar 18 10:40 AM

[User 166713:]

Mr. Buffet tells it like it is. The media made fun of him during the internet stock bubble when he said he does not buy things he does not understand. The mass media thought he was a silly old man that did not understand technology. Years later he again appeared to be the wise old man who meant to say he did not understand why internet stocks were so high with no earnings. Real estate values jumped because everyone with their hand out earned commissions on each rising sale. No Realtor, mortgage broker or appraiser in their right mind would ever say real estate is headed flat or down. They kept telling everyone real estate could not go down. Mr. B has been right in the past and will be in the future.

2008 Mar 21 05:18 PM

[a Buffet fan!:]

Warren always seems to be pragmatic not preachy. When he speaks, it appears we all should be listening carefully not critiquing what he says!

2008 Apr 08 01:16 PM

[atul sanghavi:]

With the latest events which have unfolded with the Leman brothers going under, Mr. Warrent buffet's fears of a dominos effect in the derivatives markets has sadly come true.

2008 Sep 16 05:42 AM

[User 266059:]

What will it take to have Buffett's voice be heard by those creating and enforcing policy? If I were running for President, I would want to know what it would take for him to accept the position of Chief Economic Advisor.

2008 Sep 20 11:18 AM

[A Dilbert:]

'it would seem that most investors believe it is Mr. Buffet who is the fool. I guess we'll just have to wait and see.guess we'll just have to wait and see.'

And how would you like your humble pie?

2008 Oct 17 08:05 PM