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


Richard Moore


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 

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%."

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