When billionaire investor Warren Buffett warned bluntly this week that the growing use of the esoteric financial instruments known as derivatives poses a threat to the stability of world markets, he put himself directly at odds with another financial sage, Federal Reserve Chairman Alan Greenspan.
"Derivatives are financial weapons of mass destruction," Buffett said in his annual letter to shareholders of Berkshire Hathaway Inc., of which he is chairman. "The dangers are now latent -- but they could be lethal."
Greenspan, on the other hand, believes the spread of derivatives has reduced rather than increased the risk that a wave of losses in some markets could trigger a financial crisis.
"These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient and resilient financial system than existed just a quarter-century ago," Greenspan said late last year.
Derivatives, essentially contracts whose value depends on an underlying asset, such as the value of a currency or a bushel of corn, have been controversial for years, especially as they have exploded in popularity. That's because they are basically unregulated and have played a role in several financial scandals, from the fall of Barings Bank in Britain in 1995 and the collapse in 1998 of the huge New England-based hedge fund Long-Term Capital Management to the more recent demise of Enron Corp.
The use of derivatives has grown exponentially in recent years. The total value of all unregulated derivatives is estimated to be $127 trillion -- up from $3 trillion 1990. J.P. Morgan Chase & Co. is the world's largest derivatives trader, with contracts on its books totaling more than $27 trillion. Most of those contracts are designed to offset each other, so the actual amount of bank capital at risk is supposed to be a small fraction of that amount.
Previous efforts to increase federal oversight of the derivatives market have failed, including one during the Clinton administration when the industry, with support from Greenspan and other regulators, beat back an effort by Brooksley Born, the chief futures contracts' regulator. Sen. Dianne Feinstein (D-Calif.) has introduced a bill to regulate energy derivatives because of her belief that Enron used them to manipulate prices during the California energy crisis, but no immediate congressional action is expected.
Randall Dodd, director of the Derivatives Study Center, a Washington think tank, said both Buffett and Greenspan are right -- unregulated derivatives are essential tools, but also potentially very risky. Dodd believes more oversight is needed to reduce that inherent risk.
"It's a double-edged sword," he said. "Derivatives are extremely useful for risk management, but they also create a host of new risks that expose the entire economy to potential financial market disruptions."
Buffett has no problem with simpler derivatives, such as futures contracts in commodities that are traded on organized exchanges, which are regulated. For instance, a farmer growing corn can protect himself against a drop in prices before he sells his crop by buying a futures contract that would pay off if the price fell. In essence, derivatives are used to spread the risk of loss to someone else who is willing to take it on -- at a price.
Buffett's concern about more complex derivatives has increased since Berkshire Hathaway purchased General Re Corp., a reinsurance company, with a subsidiary that is a derivatives dealer. Buffett and his partner, Charles T. Munger, judged that business "to be too dangerous."
Because many of the subsidiary's derivatives involve long-term commitments, "it will be a great many years before we are totally out of this operation," Buffett wrote in the letter, which was excerpted on the Fortune magazine Web site. The full text of the letter will be available on Berkshire Hathaway's Web site on Saturday. "In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit."
One derivatives expert said several of General Re's contracts probably involved credit risk swaps with lenders in which General Re had agreed to pay off a loan if a borrower -- perhaps a telecommunications company -- were to default. In testimony last year, Greenspan singled out the case of telecom companies, which had defaulted on a significant portion of about $1 trillion in loans. The defaults, the Fed chairman said, had strained financial markets, but because much of the risk had been "swapped" to others -- such as insurance companies, hedge funds and pension funds -- the defaults did not cause a wave of financial-institution bankruptcies.
"Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands," Buffett acknowledged. "These people believe that derivatives act to stabilize the economy, facilitate trade and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies."
But then Buffett added: "The macro picture is dangerous and getting more so. 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 nondealer counterparties," some of whom are linked in such a way that many of them could run into problems simultaneously and set off a cascade of defaults.
Susan M. Phillips, dean of the George Washington University School of Business and Public Management, who is a former member of both the Federal Reserve Board and the Commodity Futures Trading Commission, said she believes Buffett "overstated the danger" of the use of derivatives to financial markets.
"In many ways, derivatives provide stability to our markets, but they are instruments only for people who want to be in that business and have the expertise to do the valuations," Phillips said. "We have seen a lot of volatility in markets recently, and if this had happened 15 or 20 years ago, we would have seen a lot of bank failures and failures of brokerages. The use of derivatives has helped shore up the financial system."
At least at banks, Phillips said, losses on derivatives have been very small. "That's not where they lose money. It's the old-fashioned way: bad loans," she said.
E. Gerald Corrigan of Goldman Sachs Group Inc., who had extensive experience dealing with derivatives issues when he was president of the New York Federal Reserve Bank, said he believes the risk of a financial market crisis has been reduced by the widespread use of derivatives. In addition, he said, "risk management is better, supervision is better and the capital position of major financial institutions is better" than it was 10 years ago.
"What is not so clear, on the other side of the ledger, is, has the complexity [of derivatives and other new financial instruments] left the potential damage quotient higher?" Corrigan asked. The issue, he said, is whether "the use of credit derivatives left risk in the hands of people who may not understand the risk, and has the sheer growth of derivatives" increased the potential damage from a crisis should one occur.
Corrigan said he is not sure of the answer, and added, "I really do think that all of us should go back and take a look at some of these questions again."
Staff writer Kathleen Day contributed to this report.