Working Together
Thursday, March 6th, 2003One of this week’s top stories in the Business World was Warren Buffett’s warning concerning derivatives. (Fortune) (London Telegraph) The following introduction is taken from the BBC Business coverage.
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Derivatives are financial weapons of mass destruction 
The world’s second-richest man made the comments in his famous and plain-spoken “annual letter to shareholders”, excerpts of which have been published by Fortune magazine.
The derivatives market has exploded in recent years, with investment banks selling billions of dollars worth of these investments to clients as a way to off-load or manage market risk.
But Mr Buffett argues that such highly complex financial instruments are time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system.
Contracts devised by ‘madmen’
Derivatives are financial instruments that allow investors to speculate on the future price of, for example, commodities or shares – without buying the underlying investment.
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Outstanding derivatives contracts – excluding those traded on exchanges such as the International Petroleum Exchange – are worth close to $85 trillion, according to the International Swaps and Derivatives Association.
Some derivatives contracts, Mr Buffett says, appear to have been devised by “madmen”.
He warns that derivatives can push companies onto a “spiral that can lead to a corporate meltdown”, like the demise of the notorious hedge fund Long-Term Capital Management in 1998.
Derivatives are like ‘hell’
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The profits and losses from derivates deals are booked straight away, even though no actual money changes hand. In many cases the real costs hit companies only many years later.
This can result in nasty accounting errors. Some of them spring from “honest” optimism. But others are the result of “huge-scale fraud”, and Mr Buffett points to the US energy market, which relied for most of its deals on derivatives trading and resulted in the collapse of Enron.
Derivatives: Will they take down our Stock Markets?
Terence R. Wilken
The first question is what are derivatives? The second question is why may they bring down the markets? These are good questions.
A derivative is a financial security such as an option or future whose value is derived in part from the value and characteristics of another security, the underlying asset. The underlying asset is usually a commodity, bond, stock, or currency. You ìbet” that the value derived from the underlying asset will increase or decrease by a certain amount within a certain fixed period of time.
A derivative is usually a contract rather than an asset. You buy a promise to convey ownership of the asset rather than the asset itself. Because the legal term of a contract is much more varied than property ownership it has a special appeal to investors. It provides for a ìsophisticated” management of risk. This is why it appeals to the large securities firms. This form of investment certainly is not for the beginning investor.
This makes it just right for Companies such as JP Morgan, Citigroup, Golden Sachs, and Morgan Stanley. They are in the business of making as much money as possible for their Shareholders. They are large enough to take great risks with ìtheir” money. The italics are there for a purpose.
Some of these Companies suffered major losses with the collapse of Enron, Worldcom, Global Crossing, Williams Communications, and others that ran out of money. That’s because they had loaned billions of dollars to these companies. These loans were carried as “assets” on the books of the banks. But when their debtor companies collapsed, the lender ìbanks” are required to report these loans as non-performing. They are no longer assets for the bank, now they are ìlosses”. Billions of dollars in assets are suddenly billions of dollars in losses.
Not to worry, the major money that they make is made in betting with their derivatives. JP Morgan alone has over $23 trillion of derivatives on their books. They have made money on these bets in the past. What will happen if the underlying asset that they are betting on goes the wrong way? Not to worry. They have hedged their bets, and are betting both ways. What will happen if one side of the ledger ends up not having the money to pay off their bets? Remember, it takes two to bet.
Where have we heard this before. These types of transactions is what was occurring at the energy trading desk of Enron. In part it is what brought them down. Currently Dynergy may be the next Company to suffer Enronitis. Williams lost over $400 million dollars in their energy trading business, and brought them to their knees. They are currently in the process of selling off all their capital assets in order to survive. If they are able to make it, they will be a much smaller Company. Can this continue?
How many of you remember Long Term Capital Management? LTCM. It was necessary for them to be bailed out with taxpayers money.
If that is a stretch, than I am sure that there are those of you that went through the Savings and Loan crisis. Money is king, as long as you have plenty of it. If you do not, than just go to your local government and have them print some for you. Look at what just happened in Brazil. They were just at the point of defaulting on their loans.
Who loaned Brazil the money intially? Go no further than your friendly securites Companies. I cannot tell you their names, but their initials are JP Morgan Chase, and Citicorp. Together, they have outstanding loans to Brazil of ~$30 billion. Since those would not be a good loans to put in the non performing column, they had to go and get the IMF to loan Brazil money to put off the time frame for a little longer.
It is interesting that the money was given to Brazil with no conditions. They do not even have to be good boys, but now they have the funds to pay their ìbanks” the interest on their outstanding loans.
What will our Fed do next? They need to raise rates to wring out the excesses in our economy. Will this be pleasant? NO! The thing that must become known is that if they do not do this now, that it will be much worse down the road. But with elections coming our Government is afraid to raise rates. What will it do to the Stock Market? What will it do to the consumer markets ? So lets wait awhile on that one.
Instead, the talk is that money will be made much cheaper. This is going on in Japan today. Soon, at a local bank near you, they will pay you to borrow money. What do you intend to do with all that money? They are talking about reducing rates to banks to 1 %. Get ready for easy money. The true definition of inflation is that there is an increase in the money supply.
Remember the old chinese curse: “May you live in interesting times!”
It is time for all Americans to come to the realization that we will all be working until we are 80. At that time we can decide if we can afford to retire. Thank God, jobs are plentiful.
Somehow, this all reminds me of a book I read long ago, Atlas Shrugged! If you haven’t read it, you might want to take a look.
