Sage uses his onion

4 March 2003 By Chris Hughes

It sounds likes the Sage of Omaha thinks the world would be a better place without derivatives altogether. That would be silly, but he has highlighted the need for greater transparency of derivative exposures.

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Warren Buffett, chief executive of Berkshire Hathaway, said derivatives were time bombs for the economic system as well as the parties that deal in them.

He made five main criticisms:

• Reported earnings from derivatives contracts are often inaccurate. Their value depends on assumptions that are either overoptimistic or fraudulent. Traders have an incentive to cheat in calculating the market value of contracts to inflate earnings because they then getter bigger bonuses.

• Derivatesrelated receivables are often hard to turn into cash. They ultimately depend on the credit worthiness of counterparties.

• Derivative contracts can exacerbate the problems of counterparties suffering a credit downgrade. This is because collateral is often required when a derivatives counterparty is downgraded.

• Dealing in derivatives is concentrated around a few players. A derivatives counterparty in trouble quickly impacts others.

• The linkage of derivatives counterparties creates systemic risks which regulators have yet to find an effective way to control.

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, Buffett said.

Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

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