Why did Warren Buffett declare derivatives as the financial weapons?
Derivatives are often misunderstood in their own right and good strategies can be a great risk-nullifying instrument for most parties. In fact, a good derivative hedge can work for both parties ie one going long and the other going short. What are derivatives? A derivative is a financial instrument that offers a return based on the return of some other underlying asset. Having said that, the reason why Warren Buffett called Derivatives the WMD of economics are listed below. 1. There is no regulatory oversight of the markets. As you can concur from the definition, one can create as many derivatives as one wants (at least theoretically) on just one underlying asset, as long as someone is ready to take the other side of the bet. This makes the system very, very complex. There are sometimes hundreds of different spreads and bets that are for the taking with reference to the one underlying asset, say the price of a basket of 'X' stocks going south. Nobody really knows how many derivative contracts there are or even who sits on the other side of the hedge! A derivative contract sold by Meryll Lynch for example could be owned by some pension fund owner sitting far away in Europe or Asia. When the system goes bust, it is this person sitting far away from the action who is losing his money. This is a zero-sum game. For this someone to recuperate, he has to cut down on heavy spending to reign in the loss, which causes further job cuts etc in his home business. 2. Counter-party risk. In most cases, the bets are moderated by the clearinghouse wherein, each company enters into a specific contract with clearinghouse. If for example, company A wants to set a derivative contract out for getting $1,000,000 in case the interest rates hike more than a specified amount. It enters into a contract with the clearinghouse. It is then the clearinghouse then that enters into a separate contract with company B that wants a derivative contract for the exact same thing, only gets paid out when the interest rates tank compared to the specified amount. If one counter party fails to pay up the amount, it is the clearinghouse that takes the flak. There is a great liquidity and even solvency risk with regards to Black Swan events that can wipe out even the big 4 companies. In case of Meryll Lynch for example, the company tanked because it kept a lot of its toxic assets on its books, before it could actually sell them to gullible "clients." 3. A lot of power in a few hands who are too big to fail. This sometimes promotes making derivative contracts with a huge payout by gaming the system. In the latter half of the Financial musical chairs of 2007-08, the big four companies were making financial products that were gamed to make one counter party lose big time. There was a great conflict of interest, but evidently the players didn't think so. 4. The payouts. For something like Swaps ( a derivative instrument), you receive a steady income of money flowing in q-o-q or y-o-y. In the event of a debacle, wherein you have to make out a payment, the payment can be massive. Think of it like insurance. I can take an insurance out on my house. But, can you take out an insurance out on my house? What happens is if my house burns down, you get the payout. Now imagine if this system can be rigged. In derivatives, especially the ones used during the sub-prime crisis, these payouts were huge. In a free-market system, this works. And it should too. But most people don't know about the choices they make. They think they do, but man is not a rational creature, he is a rationalizing creature. 5. The numbers don't show on the balance sheet! The number of contracts that have been signed or a company is part of may perhaps be known, but the value of each contract can be measured by different metrics. The figure one holds close to heart, may actually not be true in the real world. In fact, they mostly go under the scanner. 6. Assumptions. All derivatives are calculated on the basis of some statistical assumptions. Although, they work brilliantly at most times, even the Long Term Capital Management fiasco taught us that if the margins are small, then you make more money using leverage. Now, here is the thing about leverage: when you want it, you don't get it; when you don't want it, people offer it to you no holds barred. Companies led by Nobel Award winners have tanked because they couldn't mitigate the fact that even with assumptions that can only work in certain situations, we tend to quantify and extrapolate them to work under all circumstances. It is important to know when and how the assumptions are made. Experts prior to the financial meltdown imagined that real estate only went up, clearly ignoring a small blip in the 80s wherein the prices fell. In fact, for the great amount of companies to blow up during the bubble, the real estate prices had to remain just stationary! I think this is a start. There are plenty more I'm sure, but this was all that I could come up with for now. Will add more.