Warren Buffett’s Love-Hate Relationship with Derivatives

Q1. In his 2002 letter to shareholders, what does Warren Buffett seem to fear most about financial derivatives?

Warren Buffett has long been reflected as one of the voices behind the massive land of poor business decisions even though he has won best reputation in investing. He is known for his tough talks, absolute honesty and, in some cases, blunt nature. As the chairman of the board of Berkshire Hathaway, he was concerned that he projected a significant threat to the future of business in general. He states that derivatives are financial weapons of mass destruction or, in other words, main factors for creation of a time bomb.

Financial institutions sell billions of these investments to customers as a way to cope with market risks, but these derivatives may also provide a treacherous incentive to false accounting. He goes further to say that these instruments call for money to change hands in the future with the amount determined by one or more items like interest rates and stock prices.

He then points out that these investments often invite a terrific deal of credit which may in turn lead to fall of an institution or corporate meltdown like the plunge of the hedge fund of Long-Term Capital Management in 1998. Making errors in the derivative business has never been symmetrical. According to Eiteman, Moffett & Stonehill (2009), they have favored either the CEO who is to record profits, or the trader, or both.

Q2. In his 2007 letter to shareholders, what does Warren Buffett admit that he and Charlie had done?

Buffet suggests that the Vice Chairman, Charlie Munger, also views these derivatives as time bombs set for both parties who deal with them and the economic systems. He admits that they run what has turned out to be a large business, but emphasizes that they did not plan the way that occurred. Charlie started as a lawyer, and Buffett thought of himself as a security analyst. They both grew skeptical about the ability of large institutions of any type to function well, thus appeared to make numerous establishments, slow-think and resistant to change. In fairness, they had seen truly outstanding successes, as well.

There were many massive firms and their paramount task was to sculpt and harden the institutions’ corporate culture, and make substantial capital allocation choices. Buffet admitted that they sold the company holdings for four billion dollars and that of the ninety four derivative contracts, fifty four that he managed were due to expire at various times from 2009 to 2013.

Thus, in the “Letter to Shareholders, Berkshire Hathaway: Annual Report, 2007” Eiteman, Moffett & Stonehill (2009) assert “our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings.”

Q3. Do you think there is an underlying consistency in his viewpoint on the proper use of derivatives?

Yes. The proper use of derivatives is essential in running a business. I believe that poor management of derivatives would lead to a great deal of trouble for a corporate institution. Therefore, derivatives would act as tripwires for the unsuspecting victim. He suggested that derivative contracts be guaranteed because their value depends on credit worthiness of the counter parties.

Before a contract is settled, the parties record their profits and losses without money exchanging hands. However, reported earnings on these derivatives are in most cases overestimated. For that reason, there is an underlying consistency in Buffett’s viewpoint on proper use of derivatives.