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What Had Buffet Said?
Thursday August 16, 1:04 pm ET
By Dirk van Dijk, CFA


For investors, there is one must read annual report, regardless if you own the stock or not, and that is Berkshire Hathaway (NYSE: BRK-A) for the letter from its Chairman Warren Buffet. In light of the current market turmoil, it is instructive to look at what Buffet was saying five years ago.

The situation he described regarding the large amount of derivative exposure has, of course, grown exponentially larger since he wrote it, but his words then have resonance today. The chickens that he warned of in his 2002 Annual report appear to be coming home to roost.

Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.

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Charlie and I believe, however, that the macro picture is dangerous and getting more so. 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 other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as Ive mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

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When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we dont understand how much risk the institution is running.

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The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

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In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

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In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

Warren E. Buffett

February 21, 2003

Chairman of the Board