“Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who, in addition, trade extensively with one another," Buffett said. "The troubles of one could quickly infect the others.”
Buffett owns a derivatives dealing business, General Re Securities, which he acquired when he bought its parent, insurance company General Re. He said in the letter that he and Charlie Munger, Berkshire Hathaway’s vice-chairman, did not want the derivatives business because they regarded it as "dangerous". But having failed to sell General Re Securities - first to Peter Hancock, Roberto Mendoza, Robert Merton and Doug Dachille , and then to his godson Mark Byrne - Buffet chose to wind it down. He added that it will be many years before the business is totally out of operation, even though exposure is being reduced daily.
“In fact, the reinsurance and derivatives businesses are similar: like Hell, both are easy to enter and almost impossible to exit,” said Buffett. “In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it.”
Buffett warned that parties involved in derivatives often have “enormous incentives” to cheat in accounting for them. He said that as a general rule, contracts that involve multiple reference items and distant settlement dates increase the opportunities for counterparties to use “fanciful assumptions”.
He highlighted the energy and electric utility sectors as containing examples of companies that used derivatives to report misleadingly high earnings figures “until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash”. Buffett said that mark-to-market - assigning a market value to derivatives positions - then turned to “mark-to-myth”.
US energy trader Enron went bankrupt in 2001 after it emerged that it had used derivatives to mislead investors.
Buffett also warned of the possible knock-on effects that come from a company with derivatives positions being downgraded. A credit downgrade requires the immediate supply of collateral to derivatives counterparties. He said that if a company is downgraded because of general adversity, collateral payments could throw the company into a liquidity crisis that could trigger more downgrades. “It all becomes a spiral that can lead to a corporate meltdown,” said Buffett, adding that there are also adverse knock-on effects to other companies.
The letter will be delivered to shareholders on March 8. Buffett allowed extracts to be published on Fortune magazine’s website yesterday.