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Warren Buffett: $516 trillion bubble is a disaster waiting to happen

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Richard Moore

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Mar 13, 2008, 10:04:01 AM3/13/08

http://www.marketwatch.com/news/story/derivatives-new-ticking-time-bomb/story.aspx?guid=%7BB9E54A5D%2D4796%2D4D0D%2DAC9E%2DD9124B59D436%7D&dist=TNMostRead

PAUL B. FARRELL Derivatives the new 'ticking bomb'

Buffett and Gross warn: $516 trillion bubble is a disaster waiting
to happen

By Paul B. Farrell, MarketWatch Last update: 7:31 p.m. EDT March
10, 2008

ARROYO GRANDE, Calif. (MarketWatch) -- "Charlie and I believe
Berkshire should be a fortress of financial strength" wrote Warren
Buffett. That was five years before the subprime-credit meltdown.

"We try to be alert to any sort of mega-catastrophe risk, and that
posture may make us unduly appreciative about the burgeoning
quantities of long-term derivatives contracts and the massive amount
of uncollateralized receivables that are growing alongside. In our
view, however, derivatives are financial weapons of mass destruction,
carrying dangers that, while now latent, are potentially lethal."

That warning was in Buffett's 2002 letter to Berkshire shareholders.
He saw a future that many others chose to ignore. The Iraq war
build-up was at a fever-pitch. The imagery of WMDs and a mushroom
cloud fresh in his mind.

Also fresh on Buffett's mind: His acquisition of General Re four
years earlier, about the time the Long-Term Capital Management hedge
fund almost killed the global monetary system. How? This is crucial:
LTCM nearly killed the system with a relatively small $5 billion
trading loss. Peanuts compared with the hundreds of billions of
dollars of subprime-credit write-offs now making Wall Street's big
shots look like amateurs.

Buffett tried to sell off Gen Re's derivatives group. No buyers.
Unwinding it was costly, but led to his warning that derivatives
are a "financial weapon of mass destruction." That was 2002.

Derivatives bubble explodes five times bigger in five years

Wall Street didn't listen to Buffett. Derivatives grew into a massive
bubble, from about $100 trillion to $516 trillion by 2007. The new
derivatives bubble was fueled by five key economic and political
trends:

1. Sarbanes-Oxley increased corporate disclosures and government
oversight

2. Federal Reserve's cheap money policies created the subprime-housing
boom

3. War budgets burdened the U.S. Treasury and future entitlements
programs

4. Trade deficits with China and others destroyed the value of the
U.S. dollar

5. Oil and commodity rich nations demanding equity payments rather
than debt

In short, despite Buffett's clear warnings, a massive new derivatives
bubble is driving the domestic and global economies, a bubble that
continues growing today parallel with the subprime-credit meltdown
triggering a bear-recession.

Data on the five-fold growth of derivatives to $516 trillion in
five years comes from the most recent survey by the Bank of
International Settlements, the world's clearinghouse for central
banks in Basel, Switzerland. The BIS is like the cashier's window
at a racetrack or casino, where you'd place a bet or cash in chips,
except on a massive scale: BIS is where the U.S. settles trade
imbalances with Saudi Arabia for all that oil we guzzle and gives
China IOUs for the tainted drugs and lead-based toys we buy.

To grasp how significant this five-fold bubble increase is, let's
put that $516 trillion in the context of some other domestic and
international monetary data:

U.S. annual gross domestic product is about $15 trillion U.S. money
supply is also about $15 trillion Current proposed U.S. federal
budget is $3 trillion U.S. government's maximum legal debt is $9
trillion U.S. mutual fund companies manage about $12 trillion World's
GDPs for all nations is approximately $50 trillion

Unfunded Social Security and Medicare benefits $50 trillion to $65
trillion

Total value of the world's real estate is estimated at about $75
trillion

Total value of world's stock and bond markets is more than $100
trillion

BIS valuation of world's derivatives back in 2002 was about $100
trillion

BIS 2007 valuation of the world's derivatives is now a whopping
$516 trillion

Moreover, the folks at BIS tell me their estimate of $516 trillion
only includes "transactions in which a major private dealer (bank)
is involved on at least one side of the transaction," but doesn't
include private deals between two "non-reporting entities." They
did, however, add that their reporting central banks estimate that
the coverage of the survey is around 95% on average.

Also, keep in mind that while the $516 trillion "notional" value
(maximum in case of a meltdown) of the deals is a good measure of
the market's size, the 2007 BIS study notes that the $11 trillion
"gross market values provides a more accurate measure of the scale
of financial risk transfer taking place in derivatives markets."

Bubbles, domino effects and the 'bad 2%'

However, while that may be true as far as the parties to an individual
deal, there are broader risks to the world's economies. Remember
back in 1998 when LTCM's little $5 billion loss nearly brought down
the world's banking system. That "domino effect" is now repeating
many times over, straining the world's monetary, economic and
political system as the subprime housing mess metastasizes, taking
the U.S. stock market and the world economy down with it.

This cascading "domino effect" was brilliantly described in "The
$300 Trillion Time Bomb: If Buffett can't figure out derivatives,
can anybody?" published early last year in Portfolio magazine, a
couple months before the subprime meltdown. Columnist Jesse Eisinger's
$300 trillion figure came from an earlier study of the derivatives
market as it was growing from $100 trillion to $516 trillion over
five years. Eisinger concluded:

"There's nothing intrinsically scary about derivatives, except when
the bad 2% blow up." Unfortunately, that "bad 2%" did blow up a few
months afterwards, even as Bernanke and Paulson were assuring America
that the subprime mess was "contained."

Bottom line: Little things leverage a heck of a big wallop. It only
takes a little spark from a "bad 2% deal" to ignite this $516
trillion weapon of mass destruction. Think of this entire unregulated
derivatives market like an unsecured, unpredictable nuclear bomb
in a Pakistan stockpile. It's only a matter of time.

World's newest and biggest 'black market'

The fact is, derivatives have become the world's biggest "black
market," exceeding the illicit traffic in stuff like arms, drugs,
alcohol, gambling, cigarettes, stolen art and pirated movies. Why?
Because like all black markets, derivatives are a perfect way of
getting rich while avoiding taxes and government regulations. And
in today's slowdown, plus a volatile global market, Wall Street
knows derivatives remain a lucrative business.

Recently Pimco's bond fund king Bill Gross said "What we are
witnessing is essentially the breakdown of our modern-day banking
system, a complex of leveraged lending so hard to understand that
Federal Reserve Chairman Ben Bernanke required a face-to-face
refresher course from hedge fund managers in mid-August." In short,
not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman
Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of
America's leaders can't "figure out" the world's $516 trillion
derivatives.

Why? Gross says we are creating a new "shadow banking system."
Derivatives are now not just risk management tools. As Gross and
others see it, the real problem is that derivatives are now a new
way of creating money outside the normal central bank liquidity
rules. How? Because they're private contracts between two companies
or institutions.

BIS is primarily a records-keeper, a toothless tiger that merely
collects data giving a legitimacy and false sense of security to
this chaotic "shadow banking system" that has become the world's
biggest "black market."

That's crucial, folks. Why? Because central banks require reserves
like stock brokers require margins, something backing up the
transaction. Derivatives don't. They're not "real money." They're
paper promises closer to "Monopoly" money than real U.S. dollars.

And it takes place outside normal business channels, out there in
the "free market." That's the wonderful world of derivatives, and
it's creating a massive bubble that could soon implode.

Comments? Yes, we want to hear your thoughts. Tell us what you think
about derivatives: as "financial weapons of mass destruction;" as
a "shadow banking system;" as a "black market;" as the next big
bubble dangerously exposing us to that unpredictable "bad 2%."

(233) - View Comments on this story Copyright ) 2008 MarketWatch,
Inc. All rights reserved.

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