Can Warren Buffet Be Wrong About Derivatives?
According to various press reports, in his conversation with Berkshire Hathaway shareholders, CEO Warren Buffett reiterated his concern about the use of derivatives, "saying that excessive borrowing by traders, investors and corporations will eventually lead to significant dislocation in the financial markets. In fielding a question Saturday about derivatives, which he once referred to as "financial weapons of mass destruction," Mr. Buffett told shareholders that he expects derivatives and borrowing, or leverage, would inevitably end in huge losses for many financial participants." He further added that "The introduction of derivatives has totally made any regulation of margin requirements a joke." (See "World According to Buffett: How Media, Oil -- Among Others -- Matter" by Karen Richardson, Wall Street Journal," May 7, 2007.)
We've written about derivatives many times and will continue to do so. (I've even written an entire book on the topic.)
Derivatives are everywhere in pension land. Defined benefit plans consider liability-driven investing and portable alpha strategies (often entailing the use of derivatives). On the DC side, qualified default investment alternatives sometimes involve futures, options and/or swaps. Hedging company stock in 401(k) plans might rely on the use of derivatives. Many external money managers employ derivatives and pension fiduciaries are responsible for vetting their risk process and procedures.
So the pivotal question is whether derivatives are a hindrance or a help. Certainly a market that topples $400 trillion in global size reflects widespread popularity. Like anything else, however, fiduciaries who don't understand the incremental risks are putting themselves in harm's way.
Much more to come!
