[OPE] Warren Buffet on the derivatives poker game

"A normal stock or bond trade is completed in a few days with one party
getting its cash, the other its
securities. Counterparty risk therefore quickly disappears, which means
credit problems can't accumulate. This
rapid settlement process is key to maintaining the integrity of markets.
That, in fact, is a reason for NYSE and
NASDAQ shortening the settlement period from five days to three days in
1995.

Derivatives contracts, in contrast, often go unsettled for years, or even
decades, with counterparties
building up huge claims against each other. "Paper" assets and liabilities -
often hard to quantify - become
important parts of financial statements though these items will not be
validated for many years. Additionally, a
frightening web of mutual dependence develops among huge financial
institutions. Receivables and payables by
the billions become concentrated in the hands of a few large dealers who are
apt to be highly-leveraged in other
ways as well. Participants seeking to dodge troubles face the same problem
as someone seeking to avoid venereal
disease: It's not just whom you sleep with, but also whom they are sleeping
with.

Sleeping around, to continue our metaphor, can actually be useful for large
derivatives dealers because
it assures them government aid if trouble hits. In other words, only
companies having problems that can infect
the entire neighborhood - I won't mention names - are certain to become a
concern of the state (an outcome, I'm
sad to say, that is proper). From this irritating reality comes The First
Law of Corporate Survival for ambitious
CEOs who pile on leverage and run large and unfathomable derivatives books:
Modest incompetence simply
won't do; it's mindboggling screw-ups that are required."

http://www.berkshirehathaway.com/letters/2008ltr.pdf

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Received on Sun Mar 1 07:08:07 2009