From Buffett's 2002 shareholder letter:
"Charlie 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."
"Charlie and I believe, however, that 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 derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I've mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems."
"Another problem about derivatives is that they 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. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown."
"Charlie 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."
"Charlie and I believe, however, that 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 derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I've mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems."
"Another problem about derivatives is that they 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. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown."
3 Comments:
Flounder sorry, but I have to bust your balls.
You know that Buffett dabbled in derivatives, right? Yea, Q1 profits fell 64% due to derivatives contracts. The net loss in Berkshire derivatives was $1.7 billion.
In '07 alone, BRK had 94 derivatives contracts worth $7.7 billion. This was back in 2007.
So the company's cash position dropped by $9 billion but the fact that BRK had $35.57 billion in cash left over didn't pose any harm to Buffett.
Yup, I do. But I believe Buffet was referring to derivatives like credit default swaps in the quote, like the ones that brought on AIG's troubles. I put it there because that's exactly what happened to AIG. Whether Buffet follows his own advice is entirely his own judgement :)
About Berkshire's Q1 profits, you should go through the 10-Qs. It explains his positions.
Most of the derivative exposure of Berkshire is from long-term equity put options it has written on four major stock indices, including S&P500. These are European style puts which only come due on respective expiry date (randing from 2019 to 2028). If the markets are higher than where the put was written at, Berkshire will owe nothing. The firm already holds close to $4.5B in premiums received from these and is free to invest them in anything else. However they kept a $4B or so in liabilities for possible payments in 2019-2028 as a hedge, hence the quarter.
I see it a good bet unless of course the S&P500 stays at the same level for the next 10-15 years (just as it has for the last 10 years). But then again, hehe, the sun might explode too :)
Noooooo, not the sun!
I love the sun!
waaaaaaa!
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