The Alarmist Of Omaha

Do you know what feline pride means to a money manager? (Flexible equity-linked exchangeable security.) A Synthetic CDO? If the acronyms sound exotic, the truth is that these are garden-variety derivatives, a fast-growing form of investment now used by nearly every major bank and corporation in the world. If you've got a retirement fund, your future is probably tied up one way or another in derivatives, which is why this story may alarm you. For derivatives have been making news lately both for dramatic growth--and for widening concern that they are the tangled tripwire for the next major global financial meltdown. As Berkshire Hathaway chair Warren Buffett put it recently, derivatives threaten to become "financial weapons of mass destruction."

This is not how it was supposed to work out. Derivatives are as old as civilization: Aristotle referred to an option on the use of olive-oil presses in his "Politics" some 2,500 years ago. The idea behind derivatives is to reduce risk by offering investors a chance to hedge against future movements of anything from interest rates, to commodity prices, even weather. Say you've got a lot of money in oranges--derivatives let you hedge against the risk of a cold snap. The problem: the derivatives market is now so big and so complex, the world is wagering stunning sums on bets it can't possibly understand. The market for OTC (over the counter) derivatives rose from $2.9 trillion in 1990 to $128 trillion in 2002. And while companies in the 1980s traded "plain vanilla" interest-rate swaps, since then Enron, WorldCom, Global Crossing and others have unraveled in part due to convoluted derivatives deals the forensic accountants are still trying to figure out.

Buffett is not the first to raise the alarm. As former derivatives trader and law professor Frank Partnoy outlines in a new book, "Infectious Greed: How Deceit and Risk Corrupted the Financial Markets," others tried over the past decade. In the mid-1990s, a rise in the use of OTC derivatives helped contribute to disasters like the bankruptcy of California's Orange County. According to Partnoy, calls for new market legislation were beaten back by powerful industry lobbyists. Even after the infamous hedge fund Long Term Capital Management nearly brought down world markets in 1998 thanks to complex derivatives trades concocted by Nobel Prize winners, regulators still failed to act, in part because the deals had gotten too complicated. Government accountants simply couldn't keep up.

Throughout it all, free-market advocates, including Fed Chairman Alan Greenspan, have argued that derivatives are, in fact, crucial to managing risk in a globalized world. They point to the fact that major banks have been able to maintain high levels of lending, in part because they've successfully used derivatives to move risk away from themselves. This much is true. But if the rest of the free-market thesis holds, derivative risk should end up in the hands of those who are both best able to handle it, and to quantify it.

In fact, neither seems to be the case. Consider the credit-derivatives market, which grew 37 percent in the second half of 2002 alone. Credit derivatives are basically insurance policies that allow lenders to hedge the risk of lending to a particular company. Major banks have been able to use these derivatives to offload a lot of risk, but a recent survey done by the Fitch credit-ratings agency suggests that much of the risk has been passed to the beleaguered insurance industry, which may not be able to cope with it as well as banks. Andrew Large, the new deputy governor of the Bank of England, recently expressed concern about an imminent liquidity crisis, as risk-heavy insurers are dumping equities bought in better times onto an unwilling market.

Smaller European regional banks, much less savvy than their global counterparts, have also emerged as net buyers of risk. And notoriously secretive hedge funds appear to be getting in the game, too, which may make the risks even harder to spot. In either case, the derivatives traded need not be complicated to create confusion. "Even common-vanilla derivatives can be used to hide information," says economist Randall Dodd, head of the Derivatives Study Center in Washington, D.C.