Warren Buffet has chosen a new financial weapon of mass destruction – the derivative. His comments appear to contradict the views of Alan Greenspan, the Chairman of the Federal Reserve. However, asPeter Banyard points out, the warning signs are there, and the potential risks should be of concern to all involved in the derivatives market.
Warren Buffett has become famous. Some twenty years ago, when I first started writing about him, I had to introduce him to readers. Now most people have heard of the legendary investor, the Sage of Omaha, whose value-based commercial decisions have been outstandingly successful throughout half a century. Lucky shareholders in his holding company Berkshire Hathaway have seen their investment massively outperforming the S & P 500 index in most years. For me, however, his real claim to fame lies in one year in which he under-performed. In 1999 he was 20 per cent down because he was not taken in by the dotcoms bubble. His investors saw the value of this when he outperformed the index by 15.6 per cent in 2000, 5.7 per cent in 2001 and 32.1 per cent in 2002. They have not even tasted the bitter cup that other investors have drained.
That is why the financial world listens when Mr Buffett holds forth. In late March his newsletter to shareholders in Berkshire Hathaway contained warnings so dire that the broadsheets were full of it. In effect he described derivatives as financial weapons of mass destruction. Of course he might be going in for a bit of hyperbole because the newsletter is full of folksy comment and cracker barrel wisdom, which is his style. On the other hand, he is not quite so genial and cosy in business as you might imagine. A Lloyd’s agent I know recently expressed real bitterness at the hard bargain Uncle Warren drives, but then we should expect no less. However, what intrigues me is that Mr Buffet has effectively stepped in to contest the ring with the equally legendary Mr Greenspan, chairman of the US Federal Reserve.
As I have written before, we had the benefit of some Greenspun wisdom in April 2002. His gnomic utterance that “Because of increased access to real-time information and, more arguably, extensive deregulation and innovation in financial and product markets, economic imbalances are more likely to be readily contained” is widely taken to mean that derivatives are a great way to spread credit risk through the financial system. Almost a year later we have Mr Buffett saying that derivatives may be a destructive way of concentrating risk in unexpected places. The difficulty in keeping track of these varied financial instruments means that we no longer know where the pressure points in the system are.
To give an example we might take Ford Motor Company. A recent poor trading record has seen Ford’s bonds reduced to junk status where the company has to pay seven per cent over Treasury rates. This would be a debilitating drain on the company unless it had farmed out the extra loan costs through derivatives. I suppose it would not be hard to find out with a cold towel round your head, a tinful of spinach in your stomach and the full accounts in front of you.
The trouble is that you then need to check up whether the same sap who bought Ford’s extra costs did not get loaded down with the costs from, say, Marconi, Corus and ABB. It’s only human nature to specialise in areas that you think you understand so it is fairly likely that credit derivatives are in fewer hands than we would like. A failure in some, possibly obscure, hedge company could endanger a lot of heavyweight businesses.
As usual, we have been here before. You do not even have to study economics to know about the Wall Street Crash, and it is generally agreed that the disaster was magnified by buying on margin. That is to say that shares could be bought at a fraction of their price in a futures contract. When the time came to settle the full contract the punter hoped that the shares would have gone up enough for him to have made a killing. The opposite happened in October 1929 so Wall Street slickers were seeking out high window ledges to dive from. After that trading on margin was banned but some modern derivatives, like total-return swaps, come precious close to the same thing. In a total-swap contract Party A puts up all the money to purchase some stock while Party B puts up no money but agrees that, at some future date, he will take any gain, or pay any loss, that Party A realises.
I expect that has caused one or two sharp intakes of breath from the solid professionals glued to this page. It rather bears out the golden rule that when the last witness to some financial disaster has retired, we get to work on making the same mistake again. The same cannot be said for the opacity of the system. Yes, I know, I’m making it too hard. What opacity means is that no one can reasonably know the full extent of what is going on. It seems quite respectable these days for derivatives to be held off-balance-sheet so their extent and nature is unknowable, but they might contain highly dangerous conditions. In his newsletter Mr Buffet refers to the dangers posed by a credit ratings downgrade and compares it to a spiral.
The downward spin may well begin when poor trading conditions cause a company to be downgraded. If its derivatives contracts require the company to supply its counterparties with extra cash collateral in the event of a downgrade, the situation could worsen dramatically. The downgraded company instantly experiences a liquidity crisis that triggers off a further downgrade, and that in turn calls for more cash collateral. The process can quickly ruin a solid concern through a single minor credit derating. Once again we have been here before, and recently enough for me to still feel scorched by the experience. It all happened in the reinsurance market in the early 1990s.
Reinsurance is organised in layers a bit like a club sandwich. When a primary insurer insures an oil rig he lays off a chunk of his risk; let us say that he pays a premium to a reinsurance company to pick up the tab for all losses between L10m and L50m. The reinsurer will lay off some of this exposure to another reinsurer, who might agree to pay for the slice between L20m and L40m. After that the primary insurer might decide to handle the L10m of risk between L50m and L60m but would farm out everything over that level to another reinsurer. This final guarantor would also place slices of its risk exposure with other reinsurers so, bingo, the risk is spread throughout a mighty industry; or perhaps not.
Reinsurers group their risks in different ways. Some may put this one oilrig insurance into a clutch of similar undertakings just labelled North Sea semi-submersibles. Another might just have semi- submersibles grouped together for reinsurance purposes, and another might have the risk grouped under the name of the rig’s operating company. All this actually happened so that a lot of ill-defined risk was pushed out into the reinsurance market. When the sombre day of the Piper Alpha tragedy came, the cost was not as widely dispersed as it might have been. A small number of reinsurers found that they had much more exposure to this single catastrophe than they had imagined and suffered shocking losses.
It is quite possible, indeed probable, that the same sort of opacity exists in credit derivatives. It is entirely possible that a lone reinsurer is due to pay far more to cover a single massive bankruptcy than it realised when accepting the contracts. To quote Mr Buffet’s newsletter again: “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 another. 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 are linked in ways that could cause them contemporaneously to run into a problem because of a single event (such as the precipitous decline in the value of merchant power projects).” The upshot of it all is that Berkshire Hathaway is getting out of derivatives as fast as it can.
So we have had the warning and I suggest we give it serious consideration. Derivatives are now so universally used that all banks and most other major enterprises have them. Some of those uses might seem to be very sensible. As a for instance, a life insurance firm might go into the total-swap market to keep its reserves steady in the face of great share price volatility. So far so good, but you then have to check up on the financial strength of the counterparty to make sure it can meet its obligations under all circumstances. Since a typical hedge fund may hold thousands of contracts I venture to suggest that you could find that impossible. So, on the face of it, the derivative provides financial security. The reality might be very different. My suggestion therefore is that all credit risk derivatives be treated as a risk themselves and never accepted as security.
This may seem an extreme position but I take Mr Buffet’s warnings seriously. And, after all, there was a time when firms could do business without derivative cover simply by not over-reaching themselves. We might do everyone a favour by pioneering the treatment of derivatives as dangerous, oddball stuff that does not provide financial security. Cm
… we no longer know where the pressure point\s in the system are.
Reinsurance is organised in layers – a bit like a club sandwich.
Copyright Institute of Credit Management Ltd. May 2003
