In 1988, then-Fed chairman Alan Greenspan stated, "What many critics of equity derivatives fail to realize is that the markets for these instruments have become so large not because of slick sales campaigns, but because they are providing economic value to their users."

But not everyone had a good feeling about this financial instrument. In his 2002 Berkshire Hathaway letter to shareholders, company chairman and CEO Warren Buffett expressed his concern with derivatives, referring to them as "weapons of mass destruction," a term popularized by George W. Bush to describe nuclear arms. How is it possible that two wise, well-respected financial gurus could have such differing opinions? Unfortunately, this is not a question with a simple answer.

The Story Behind Buffett's Perspective
Buffett's perspective may well have been driven by his own experience with some derivative positions he inherited as a result of Berkshire's $22 billion purchase of General Reinsurance Corporation in 1998 (the largest U.S. property and casualty reinsurer at the time). The General Reinsurance purchase also included 82% of the stock of Cologne Reinsurance, the oldest reinsurer in the world. This acquisition represented reinsurance and operations of all lines of insurance in 124 countries. It was a seemingly excellent strategic endeavor in consideration of globalization, and was heralded as the next frontier.

General Reinsurance Securities, a subsidiary of General Reinsurance initiated in 1990, was a derivatives dealer tied to global financial markets. Unfortunately, this relationship had unpredictable consequences. Buffett wanted to sell the subsidiary, but he could not find an agreeable counterparty (buyer). So, he decided to close it, which was easier said than done, as this decision required him to unwind the subsidiary's derivative positions. He likens this unwinding task to entering hell, stating that derivatives positions were "easy to enter and almost impossible to exit." As a result, General Reinsurance recorded a $173 million pretax loss in 2002.

In Buffett's 2002 letter to shareholders, he describes derivatives as "time bombs" for all parties involved. He goes on to temper this statement by saying that this generalization might not be judicious because the range of derivatives is so great. His derogatory comments about the specific derivatives he inherited appear to be directed toward those that create vast leverage and are involved in counterparty risk.

Derivatives Explained
In the broadest sense, derivatives are any financial contracts that derive their value from underlying assets. This brief definition does not, however, really give a true idea of what a derivative is or what it could be. In reality, these instruments run the gamut from the simplest put option purchased to hedge one's personal stock position, to the most sophisticated, dynamic, financially-engineered, swapped, strangled and straddled package of bits and pieces. The derivatives market is large (about $516 trillion in 2008) and experienced very rapid growth through the late '90s and early 2000s. As such, it is a grave mistake to simply leave the definition of a derivative as a financial weapon of mass destruction without expounding on what makes some derivatives fall into this category, while others are as simple as buying homeowner's insurance. One should take heed of former SEC chairman Arthur Leavitt's 1995 caveat that "derivates are something like electricity; dangerous if mishandled, but bearing the potential to do good."

Buffett's Prophecy
Since Buffett first referred to derivatives as "financial weapons of mass destruction," the potential derivatives bubble has grown from an estimated $100 trillion to $516 trillion in 2008, according to the most recent survey by the Bank of International Settlements. In addition, 2008 was marked by Société Générale's Jerome Kerviel's orchestration of the largest bank fraud in world history via derivatives trading (a £3.6 billion loss). This makes previous rogue trader incidents pale in comparison:

  • Nick Leeson at Barings Bank in 1995 (a £791 million loss and bankruptcy for his employer)
  • National Westminster Bank PLC in 1997 (a $125 million loss)
  • John Rusniak at Allied Irish Bank in 2002 (a $691 million loss)
  • David Bullen and three other traders at National Australia Bank in 2004 (a $360 million loss)

Even in other derivatives arenas, the stakes appear to be increasing at an equally alarming rate. For example, Orange County, California lost $1.7 billion in 1994 from debt and derivatives used to expand its investment fund and Long Term Capital Management lost $5 billion in 1998.

Financial Trickery Easy to Do
Buffett references the dangers of derivative reporting on and off the balance sheet. Mark-to-market accounting is a legal form of accounting for a venture involved in buying and selling securities in accordance with U.S. Internal Revenue Code Section 475. Under mark-to-market accounting, an asset's entire present and future discounted streams of net cash flows are considered a credit on the balance sheet. This accounting method was one of the many things that contributed to the Enron scandal.

Many people attribute the Enron scandal entirely to cooking the books or accounting fraud. In fact, marking to the market or "marking to the myth," as Buffett so aptly christened it, also plays an important role in the Enron story. Mark-to-market accounting is not illegal, but it can be dangerous.

Buffett suggests that many types of derivatives can generate reported earnings that are frequently outrageously overstated. This occurs because their future values are based on estimates; this is problematic because it is human nature to be optimistic about future events. In addition, error may also lie in the fact that someone's compensation might be based on those rosy projections, which brings issues of motives and greed into play.

The Unwinding of General Reinsurance
Buffet gave an update on the General Reinsurance situation in his 2003, 2004 and 2005 letters to shareholders. In his 2006 letter, Buffett stated that he was happy to report that it would be his last discussion of the General Reinsurance derivatives mishap, which, as of 2008, had cost Berkshire $409 million in cumulative pretax losses. In his 2007 letter, Buffett indicated that Berkshire had 94 derivative contracts, along with only a few remaining positions from General Reinsurance. These included 54 contracts that required BK to make payments if certain high-yield bonds defaulted, and a second category of short European put options on four stock indexes (the S&P 500 and three foreign indexes). Buffett stressed that with all of these derivative positions, there is no counterparty risk and the accounting of profits and losses are transparent. He referred to derivatives being valuable on a large scale to facilitate certain investment strategies.

Does Anyone Know this Rabbit Hole?
Did Buffett, one of the world's richest men and an investing icon, foresee a future that others chose to ignore? Say what you will about Buffett's folksy attitude toward finance, the bottom line is that he has outperformed nearly every investor alive while growing his company into one of the world's largest corporations. In his March 2007 Condé Nast Portfolio article, Jesse Eisinger poses the question, "If Warren Buffett can't figure out derivatives, can anybody?" Markets have become vastly more complex over just the last 100 years and are increasingly linked in ways that regulators and even folks of the highest financial caliber struggle to understand. Treasury Secretary Henry Paulson confirmed this sentiment in his March 14, 2008, televised statement on liquidity issues at Bear Stearns. The binding threads that run throughout these vast financial galaxies are derivatives, and the brightest minds on Wall Street worry about how they work - especially as stock markets around the world become more unpredictable and complex.

The Bottom Line
Buffett's 2002 description of derivatives as financial weapons of mass destruction may have been more of a prophecy than anyone could have realized at the time. The key here is that there are many different types of derivatives; they aren't all equally destructive. Therefore, it is extremely important to understand exactly what one is dealing with before an intelligent assessment can be made.

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