Actually, Warren Buffett Was WRONG About Derivatives: Richard Sandor

[indythinker85]

http://finance.yahoo.com/blogs/daily-ticker/actually-warren-buffett-wrong-derivatives-richard-sandor-140540626.html

[LC]

Kind of a simplistic article...most people know there are multiple uses for derivatives...it works well until everyone abuses the embedded leverage and it blows up.

 

Buffett's point in my opinion was that the EMBEDDED LEVERAGE is the destructive part of derivatives: this leverage causes people to make poor decisions.

[zarley]

Also recall that the weapons of mass destruction comment was not long after the General Re purchase. Warren moved quickly to significantly reduce the derivatives book at General Re, incurring losses along the way. 

 

From the 2008 Annual Report:

When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.

 

I think he saw what was happening inside General Re and started to realize how dangerous the derivatives practices at large financial institutions had become.  He may have seen the the potential to destroy Berkshire in those contracts and knew what needed to be done.  Booking $400 million in loses on those contracts may have been one of the best investments Buffett ever made -- consider how badly that might have gone if those contracts blew up during the crisis.