06/05/2009 05:12 am ET | Updated May 25, 2011

Derivatives: The Crystal Meth of Finance

In May 2008, Warren Buffett, the great "value" investor from Omaha and America's second-richest man, announced on the eve of his annual shareholders' meeting that he had lost $1.6 billion in bad bets on derivatives. Most of this loss came from shorting put derivatives on Standard and Poor's Index of 500 leading stocks and on three other foreign stock indexes in Europe and Japan. In laymen's terms, Mr. Buffett had placed a bet--a very large bet, which wiped out 64% of Berkshire Hathaway's profits--that global stock markets would rise instead of fall.

Preparing for this year's shareholders' meeting, Mr. Buffett announced in February 2009 that his gambling on derivatives had resulted in an "accounting loss" of $14.6 billion, with $10 billion of this loss coming from his wrong-way bet that global stock prices would rise. On the eve of the meeting itself, on May 2nd, the New York Times reported that Buffett's "worst-case exposure" had risen to $67 billion. After the company's fourth quarter net income fell 96%, Berkshire was stripped of its triple-A debt rating by both Fitch and Moody's, and this was in spite of the fact that Buffett owns twenty percent of Moody's parent company.

How could the Oracle of Omaha be getting burned by derivatives? Was this the same Warren Buffett who in 2002 warned that "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal"? Buffett had promised his shareholders that he would avoid these "time bombs ... for ... the economic system," but here he was, seven years later, announcing that the crystal speed of derivatives had got a fearsome hold on him.

Derivatives have got a fearsome hold on all of us, but my fellow journalists, who missed the story in the first place, are still avoiding the subject. They file an avalanche of twitters describing every move made by someone like Bernie Madoff, because this is a story anyone can understand. "I trusted the guy. I gave him my money. He stole it." Camera cues to tears glistening on cheeks. It's a wrap.

But derivatives? Financial weapons of mass destruction? Shorting puts on the S&P 500? Whoa, man, how am I going to get my mind around this story? How am I going to explain the exquisite pleasure that comes from using this crystal meth of finance? Why do derivatives exist in the first place, and why have they become the world's biggest betting parlor, in spite of the fact that no one understands the size or nature of these bets?

As the Oracle of Omaha confessed in his recent letter to shareholders,

"Improved 'transparency'--a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks--won't cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives."

Buffett goes on to say,

"Auditors can't audit these contracts, and regulators can't regulate them. When I read the pages of 'disclosure' in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don't know what is going on in their portfolios (and then I reach for some aspirin)."

By now the entire world is joining Mr. Buffett in reaching for some aspirin. Why, for example, did AIG, the biggest financial meth freak on the street, refuse for six months to report on what it had done with the $200 billion that the United States Treasury has dumped into its coffers, and why is there still no public disclosure of the company's assets and liabilities? The answer to the first question is that both AIG and the U.S. government were too embarrassed to announce, in this age of global markets, that much of the bailout money has gone overseas, with sixteen of the top twenty-two recipients being foreign banks. And how much more money will be required to keep AIG in the game? No one knows the answer to this question, or, to quote the great physicist Neils Bohr, "Prediction is difficult, especially of the future."

So why have derivatives got such a fearsome hold on our financial system? What is this speedy form of finance, and why, assuming that we will not be setting the clock back to Year Zero, will derivatives be around--transformed and traded differently, perhaps, but around--for the foreseeable future?

A derivative is something that takes its value from something else. It is a bet on a bet, a second order gamble that General Motors stock will rise or fall or that the S&P Index of 500 stocks (which includes General Motors) will rise or fall. As the Oracle of Omaha wrote in his 2002 letter to Berkshire Hathaway shareholders:

"derivatives for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. If, for example, you are either long or short [on] an S&P 500 futures contract, you are a party to a very simple derivative transaction--with your gain or loss derived from movements in the index."

These deals get more complicated when you start betting on household mortgages or car or student loans. The underlying transactions are sliced and diced into financial securities that are tied to interest rate fluctuations or some other aspect of currency or financial futures.

The key word here is "future." If I sell you a share of General Motors stock, you pay me, and the deal is done. If I sell you a derivative contract with General Motors sliced into it, I am selling you a contingent future payment for which I could be liable twenty years down the road.

This is why my friends in finance like derivatives. They see them as a kind of voting system, where today's prices reveal people's expectations about the future. But this is also why Warren Buffett calls derivatives "financial weapons of mass destruction." Given the boom and bust nature of capitalism, betting that the markets will not explode twenty years down the road is a matter of faith, not finance.

Exploded derivatives contracts are called toxic waste, and the institutions holding these bad bets are called zombies, because they would be bankrupt and buried save for the public handouts that keep them among the "living dead." We have borrowed these terms from epidemiology and Afro-Caribbean voodoo because the situation is really quite terrifying.

Let's start with a simple question. How big is the market in derivatives? No one knows, because no one has been recording or regulating these contracts, many of which are traded over-the-counter via telephone calls or electronic signals from one banker or hedge fund trader to another. Derivatives are a kind of "shadow banking system" because the black box trading systems that deal in them can easily shade into black market operations good at money laundering, tax evasion, or outright theft.

Tom Foremski, a former reporter for the Financial Times, and British analyst D. K. Matai, using data compiled in 2007 by the Bank for International Settlements in Basel, Switzerland, estimate that the outstanding notional value of derivatives is $1.144 quadrillion. To help you get your mind around this number, we are talking about more than a thousand trillion dollars. This sum is made up of $548 trillion in listed credit derivatives and $596 trillion in over-the-counter derivatives, which includes trading on interest rates ($393 trillion), credit default swaps ($58 trillion), foreign exchange ($56 trillion), and commodities ($9 trillion).

These numbers indicate the face value of contracts currently traded, but if any of these contracts were to default, which has been happening recently with some frequency--either because the financial markets have frozen up or the financial institutions trading these contracts have gone belly up--then the numbers would be discounted. So instead of saying that the world is currently on the hook for a quadrillion dollars in derivatives, let's cut the number in half and say that the world's derivative bubble is only $500 trillion.

How big is $500 trillion?

The gross domestic product of the United States is $15 trillion. The money supply of the United States--all the greenbacks currently in circulation--is also about $15 trillion. The gross domestic product of the entire world is $50 trillion. The total value of the world's real estate is $75 trillion. The value of the world's stock and bond markets is about $100 trillion.

As you can see, the world's derivative markets--even with a "half-price" sticker of $500 trillion--are huge, and if somebody as smart as Warren Buffett can get burned by trading derivatives then imagine how the rest of us suckers are faring. Lest you think that you, oh, virtuous reader, would never dabble in derivatives, stand warned that TIAA-CREF, Fidelity, and other guardians of your financial futures are big players in the world's derivative markets. As the Oracle of Omaha wrote in 2002: "The range of derivative contracts is limited only by the imagination of man (or sometimes, it seems, madmen)."

Again, I hate to disabuse any of you readers who are Marxists, Maoists, anarcho-syndicalists, or goldbugs, but, unless we crank the clock back to Year Zero and bring Pol Pot out of the jungle to reorganize our financial system, derivatives are here to stay. A few flavors might disappear off the menu. One example is the formerly-trendy product known as "portfolio insurance," which blew up during the crash of 1987, when the markets began gapping downward so fast that the "insurance" written against this risk proved worthless.

The market in mortgage-backed securities--frozen last fall but thawed this spring with TARP money--will return. The market in asset-backed securities (covering things such as student loans), which was dead in its tracks last fall, until being resurrected with TALF money, will return. The market in credit default swaps (CDSs), which was suffering from an absence of liquidity that resulted in hair-raising volatility, will return. Foreign exchange rate derivatives, commodity derivatives, equity-linked derivatives, all will be with us next year.

And why is this? Derivatives are fun. Trading shares in G.M. is grandad's game. Trading puts on the FTSE with a LIBOR chaser is the hepped up work of testosterone-driven bonus boys. Derivatives are useful. They speed up the velocity with which money changes hands, and increased velocity means more volume. Playing the overnight float in the Asian markets and then zipping your money back for a day's work at the Merc effectively doubles your bank, even before you get the mojo going that allows you to leverage your investment ten-fold.

Derivatives fill out the mathematical space of financial markets (an argument made best by quants and computers). They lay off risk--or so say my financial friends, when they are not being blown up by bad bets. Derivatives do the work of Adam Smith's invisible hand. They transmogrify individual greed into the collective good. They exist not because they are complicated, but because people find them useful--and I am not talking merely about the dealers who profit from them.

The world economy sits on top of the world financial markets, and there is no hope of engineering an economic recovery without a functioning financial system. This is why the government is printing money and pumping it as fast as possible into TARPs, TALFS, and other bailouts designed the get the markets back in business--not the markets that deal in stocks and commodities, but those that operate in the high-speed world of derivatives. This is the big financial story of the day, and any journalist interested in doing more than compiling an updated version of Gustave Flaubert's Dictionary of Received Ideas should be covering this story.