BULLS & BEARS: Derivatives’ linking nature worries analysts, investors

Berkshire Hathaway’s chairman, Warren Buffett, has described derivatives as “time bombs” and “financial weapons of mass destruction.” Charlie Munger, Berkshire’s vice chairman, labeled the accounting used in derivative transactions as “sewage.”

What is it about these mysterious financial instruments that evoke such ominous warnings from highly sophisticated investment minds?

First, derivatives cover a wide range of financial instruments. The word describes their function, since the future value of a derivative contract is derived from the movement of one or more items, such as interest rates, stock prices or currency values. For example, if you buy a Standard & Poor’s 500 futures contract, which is a simple derivative contract, your gain or loss is derived from movements in the index.

The derivatives markets are massive. The notational value of outstanding derivative contracts in the commercial banking system is $88 trillion. Five commercial banks hold $82 trillion, or 96 percent, of the total derivatives in the banking system. The largest, New York-based J.P. Morgan Chase, holds $45 trillion of the total outstanding derivative contracts. As Jim Grant of Grant’s Interest Rate Observer noted, “So dominant is Morgan Chase in the derivatives market that its exposures look like typographical errors.”

Of major concern to these astute investors is the chain-like linkage that exists across the derivatives markets, particularly since the value of a derivative contract is dependent on the creditworthiness of the various parties in the transaction. In the event of financial stress, the default on a derivative contract by one company could spiral down the chain and affect other institutions.

An example of such an event might be a downgrade in a company’s credit rating, which, by terms of the contract, may require more cash collateral to be supplied. If a certain company or industry were to experience a liquidity crisis, it could trigger further downgrades, creating a domino effect.

The accounting for derivatives transactions is, well, Charlie Munger said it best. Errors in derivatives accounting are responsible for the multibillion-dollar earnings restatements at Freddie Mac and Fannie Mae.

Fraudulent derivative accounting in the energy and electric utility industry was rampant in the late 1990s, and contributed to the distress and bankruptcy of several companies, including Houston-based Enron Corp. Until the implosion, companies were reporting impressive “earnings” gains, which enabled executives to earn large bonuses and reap enormous profits from stock options. Only later did the shareholders learn the reported earnings were phony.

Many contend the use of derivatives allows companies the opportunity to transfer risks they may not be able to bear to stronger companies, which in practice is true. What alarms the big-picture thinkers, however, is the rapid growth in derivatives, the concentration of derivatives in the hands of a few large banks, and the system-wide link of the parties to derivative transactions. The strength of a derivatives contract is only as good as the parties to the particular transaction.

The complexity of many derivative contracts can make even the most sophisticated investors’ heads spin. Investors should be aware that fast growth in financial institutions sometimes masks underlying problems.