Case 1: Warren Buffet

Case 1: Warren Buffet

1. 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 counter-parties.

   • 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.

2. I view derivatives as time bombs, both for the parties that deal in them and the economic system.

   • Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them.
     • Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

3. 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 participants.
     • 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.

4. Derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions

   • Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts.
     • Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

5. " In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

6. "Risk comes from not knowing what you're doing."