Buffett: Derivatives Still a Ticking Time Bomb

Created: June 02, 2010 14:24 | Last updated: July 31, 2020 00:00

I’ll have a story up soon on today’s testimony from Warren Buffett, the head of investment giant Berkshire Hathaway, to the Financial Crisis Inquiry Commission on the role of credit rating agencies in the financial crisis and recession.

But here’s one nugget. Brooksley Born, the former head of the Commodity Futures Trading Commission, which regulates certain kinds of derivatives, used her time to ask Buffett multiple questions about the financial instruments, contracts derived from the price of another asset that will come under new regulation once the financial regulatory reform bill passes. Derivatives trading accounts for up to 40 percent of revenue at some Wall Street banks, and their regulation is the subject of intense lobbying by financial firms that do not want to have to exchange-trade derivatives or put trades through clearinghouses.

Born quoted Buffett’s shareholder letters declaring derivatives “financial weapons of mass destruction, carrying dangers that while now latent are potentially lethal” and “time bombs both for the parties that deal in them and the economic system.”

In response to questions about the instruments, Buffett said that derivatives “accentuated enormously the leverage in the system” and contributed to the financial collapse. He described his acquisition of reinsurance company GenRe, which came with 23,000 derivatives contracts, and how he sold off all of them for $400 million at a loss because he felt he could not understand them. “It was impossible,” he said, noting he had never heard of most of the counterparties and “couldn’t pronounce their names.”

“The only answer was to get out of the business,” he said.

Born asked whether major investment banks, such as J.P. Morgan Chase, have the capacity to understand their derivatives contracts and their risks. Buffet replied, “I think they’re dangerous. I’ll say this: I don’t think I could manage them. … It’s hard for me to imagine a regulatory system that could supervise something like that.”

Finally, Born asked him, “In your view, is the derivatives market still a time bomb ticking away?”

Buffett responded, “I would say so.”