Following are edited excerpts
Hathaway annual report for 2002.
I view derivatives as time bombs, both for the parties
that deal in
them and the economic system. Basically these instruments call
money to change hands at some future date, with the amount to be
by one or more reference items, such as interest rates, stock prices,
currency values. For example, if you are either long or short an
500 futures contract, you are a party to a very simple derivatives
with your gain or loss derived from movements in the index. Derivatives
contracts are of varying duration, running sometimes to 20 or more
and their value is often tied to several variables.
Unless derivatives contracts are collateralized or
ultimate value also depends on the creditworthiness of the
to them. But before a contract is settled, the counter-parties record
and losses – often huge in amount – in their current earnings
without so much as a penny changing hands. Reported earnings on
are often wildly overstated. That’s because today’s earnings are in a
way based on estimates whose inaccuracy may not be exposed for many
The errors usually reflect the human tendency to take an
view of one’s commitments. But the parties to derivatives also have
incentives to cheat in accounting for them. Those who trade derivatives
are usually paid, in whole or part, on “earnings” calculated by
accounting. But often there is no real market, and “mark-to-model” is
This substitution can bring on large-scale mischief. As a general rule,
contracts involving multiple reference items and distant settlement
increase the opportunities for counter-parties to use fanciful
The two parties to the contract might well use differing models
both to show substantial profits for many years. In extreme cases,
degenerates into what I would call mark-to-myth.
I can assure you that the marking errors in the
have not been symmetrical. Almost invariably, they have favored either
the trader who was eyeing a multi-million dollar bonus or the CEO who
to report impressive “earnings” (or both). The bonuses were paid, and
CEO profited from his options. Only much later did shareholders learn
the reported earnings were a sham.
Another problem about derivatives is that they can
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
Imagine then that a company is downgraded because of general adversity
and that its derivatives instantly kick in with their requirement,
an unexpected and enormous demand for cash collateral on the company.
need to meet this demand can then throw the company into a liquidity
that may, in some cases, trigger still more downgrades. It all becomes
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. In both cases, huge receivables from many counter-parties tend
to build up over time. A participant may see himself as prudent,
his large credit exposures to be diversified and therefore not
However under certain circumstances, an exogenous event that causes the
receivable from Company A to go bad will also affect those from
B through Z.
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
the failure of weak banks would sometimes put sudden and unanticipated
liquidity demands on previously-strong banks, causing them to fail in
The Fed now insulates the strong from the troubles of the weak. But
is no central bank assigned to the job of preventing the dominoes
in insurance or derivatives. In these industries, firms that are
solid can become troubled simply because of the travails of other firms
further down the chain.
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
On a micro level, what they say is often true. I
believe, however, that
the macro picture is dangerous and getting more so. Large amounts of
particularly credit risk, have become concentrated in the hands of
few derivatives dealers, who in addition trade extensively with one
The troubles of one could quickly infect the others.
On top of that, these dealers are owed huge amounts by
Some of these counter-parties, are linked in ways that could cause them
to run into a problem because of a single event, such as the implosion
of the telecom industry. Linkage, when it suddenly surfaces, can
serious systemic problems.
Indeed, in 1998, the leveraged and derivatives-heavy
activities of a
single hedge fund, Long-Term Capital Management, caused the Federal
anxieties so severe that it hastily orchestrated a rescue effort. In
Congressional testimony, Fed officials acknowledged that, had they not
intervened, the outstanding trades of LTCM – a firm unknown to the
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
to other financial institutions had the LTCM domino toppled. And this
though it paralyzed many parts of the fixed-income market for weeks,
far from a worst-case scenario.
One of the derivatives instruments that LTCM used was
contracts that facilitate 100% leverage in various markets, including
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
loss that the bank realizes.
Total-return swaps of this type make a joke of margin
Beyond that, other types of derivatives severely curtail the ability of
regulators to curb leverage and generally get their arms around the
profiles of banks, insurers and other financial institutions.
even experienced investors and analysts encounter major problems in
the financial condition of firms that are heavily involved with
The derivatives genie is now well out of the bottle, and
will almost certainly multiply in variety and number until some event
their toxicity clear. Central banks and governments have so far found
effective way to control, or even monitor, the risks posed by these
In my view, derivatives are financial weapons of mass destruction,
dangers that, while now latent, are potentially lethal.