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Bugget disarm derivatives now { March 5 2003 } Original Source Link: (May no longer be active)
http://www.guardian.co.uk/business/story/0,3604,907660,00.htmlhttp://www.guardian.co.uk/business/story/0,3604,907660,00.html
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Let's disarm those derivatives now
Buffett points to unlearned lesson
Wednesday March 5, 2003
The Guardian
This weekend Warren Buffett, the world's best known investor, dispatches his annual letter to shareholders in his investment company, Berkshire Hathaway.
Embarrassingly, this year most of the contents have leaked - to a magazine website, Fortune.com. So we know in advance about the great man's theme: derivatives.
In Buffett's opinion, these complex financial instruments, which give investors and speculators economic exposure to a security without actually owning it, are "financial weapons of mass destruction".
In his typically blunt way, he reckons they threaten to destabilise the US economy, and presumably our economy too. He notes that institutions which trade in derivatives can find it difficult to bale out when the going gets tough, storing up future liabilities that could spark terrible chain reactions.
"Like hell, both are easy to enter and almost impossible to exit. In either, once you write a contract - which may require a large payment decades later - you are usually stuck with it," he is expected to tell his investors.
Mr Buffett, of course, has had close-hand experience of out of control derivative positions threatening to destabilise the financial system. He was the man Wall Street turned to in August 1998 when the Russian debt default and a resulting explosion in credit spreads brought Long Term Capital Management to the brink.
The hedge fund, with more than $100bn of outstanding crisscrossing trades, needed several billion dollars to keep it solvent. Goldman Sachs almost convinced Mr Buffett that he was the man who should inject the money - but only almost. In the end, at the behest of the Federal Reserve, it fell to a long list of crippled banks across Wall Street, London and continental Europe to chip in a few hundred million apiece in order to avoid the system being tested with a default of such magnitude.
History may one day show that Buffett was right to refuse to bail out LTCM - and that the Fed was wrong to sponsor the rescue of a private investment vehicle.
The period from the moment of the hedge fund's rescue in the autumn of 1998 through to the spring of 2000, when stock markets around the world hit their peak, will go down as one of the greatest financial bubbles ever.
It is because the system was allowed to career on unchecked that we are now sitting three years into a bear market with no sign whatsoever of an upturn. It is because of an explosion in the use of derivatives of all types and across all sectors that today financial regulators probably have less of a handle on the possible systemic impact of a big collapse than they did at the time of LTCM. In short, the financial world seems to have learned nothing at all.
Mr Buffett's comments should be read and re-read. He has been investing for 61 years - and not as the sort of folksy armchair punter as he is often described. He has played at the sharp end and knows about how words such as "derivatives" tend to involve something called "leverage", which in turn adds up to thing commonly known as "risk".
Too many people in the modern financial markets don't understand those words at all.
Wim gains vim
Wim Duisenberg, Europe's top central banker, is a late convert to the cause of proactive interest rate cuts.
After his remarks that growth in Europe is failing to meet expectations, delivered at last weekend's meeting of central bankers and finance ministers in Paris, the European Central Bank is widely expected to cut rates at its meeting tomorrow.
But for Europe's struggling economies even a 50 basis point cut is too little, too late. The Bank has been too slow to act because it is fixated by its mandate to keep inflation below 2% at all times. Frustration is clearly growing among the other leading economies - the US treasury secretary, John Snow, said yesterday that America was carrying the rest of the world.
Britain's top central banker, Sir Eddie George, tried to excuse the ECB's tardiness yesterday, telling MPs on the Treasury select committee that the ECB was still in a "very early stage" of its history. Yet the argument that Frankfurt has to take a tough line against inflation because it is still establishing its credibil ity with the markets won't wash. Threadneedle Street has been setting rates for only 18 months longer than the ECB but is clearly doing a superior job.
Sir Eddie underlined the advantages of Britain's inflation targeting regime to MPs. The symmetrical target and the longer forecast horizon allow the Bank to be more flexible in its approach than the ECB's stricter remit.
Unlike the ECB's forecasters, who have been obsessed by the inflationary spike caused by soaring oil prices, the Bank recognises that higher energy costs suck demand out of an economy, and that their price effects are secondary.
Even his impending retirement could not tempt the canny governor into expressing an opinion to MPs on the euro debate. But Sir Eddie's enthusiasm for the current monetary and fiscal arrangements highlights what Britain would be giving up if it joined the single currency.
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