What Is a Derivatives Time Bomb?
A derivatives time bomb refers to the market mayhemthat could be caused by a sudden, as opposed to orderly, unwinding ofmassive derivatives positions. The legendary investor Warren Buffett is credited with the concept, and he has voiced his concerns about derivatives repeatedly over the years. This article looks at what he means.
Key Takeaways
- Derivatives time bomb refers to the potential for a dramatic disruption of the financial system and overall economy caused by a sudden unwinding of derivatives positions.
- The term is credited to the famous investor Warren Buffett, who has also called derivatives "financial weapons of mass destruction."
- A derivative is a financial contract whose value is tied to an underlying asset. Common derivatives include futures contracts and options.
- Derivatives can be used to hedge price risk as well as for speculative trading to make profits.
- Derivatives in the mortgage market were a major cause of the 2007-2008 financial crisis.
- Since that time, the U.S. government has implemented new regulations aimed at reducing derivatives' potential for destruction.
Understanding a Derivatives Time Bomb
Referring to derivatives in his 2002 chairman's letter for his holding company Berkshire Hathaway, Warren Buffett wrote, "We view them as time bombs, both for the parties that deal in them and the economic system." Later in the same letter, he added, "derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
Buffett went further a few years later, devoting a lengthy section to the subject in his 2008 annual letter. He bluntly stated: "Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years."
In 2016, at the annual Berkshire Hathaway company meeting, he warned that the state of the derivatives market was "still a potential time bomb in the system—anything where discontinuities can exist, can be real poison in markets."
Note
In 2018, the Vatican joined in the criticism, referring to some types of derivatives as creating "a ticking time bomb ready sooner or later to explode, poisoning the health of the markets."
What Is a Derivative?
A derivative is a financial contract whose value is tied to an underlying asset. Futures and options are common types of derivatives. Institutional investors use derivatives to either hedge their existing positions or speculate on various markets, whether equities, credit, interest rates, or commodities.
Even Warren Buffett uses derivatives when he sees an opportunity, but in a manner that he believes is prudent and won't risk a large financial loss. He primarily does this when he believes certain contracts are mispriced, as he explained in his 2008 Berkshire Hathaway annual letter.
At that time, the company held 251 derivatives contracts that he believed were mispriced at inception. Furthermore, those contracts did not have to post significant collateral if the market moved against them, Buffett wrote.
The Dangers of Derivatives
Although derivatives canmitigate portfolio risk, institutions that are highly leveraged can suffer huge losses if their positions move against them. The world learned this during the financial crisis of 2007-2008, especially the subprime mortgage meltdown, driven by a type of derivative called mortgage-backed securities (MBS).
A number of well-known hedge funds have also imploded as their derivatives positions declined dramatically in value, forcing them to sell their securities at markedly lower prices to meet margin calls and customer redemptions.
One of the largest and earliest hedge funds to collapseas a result of adverse movements in its derivatives positions was Long-Term Capital Management (LTCM). But this late 1990s event was a mere preview for the main show in 2007-2008.
New Laws to Defuse the Time Bomb
Financial regulations implemented since the 2007-2008 crisis have attempted to tamp down on the risk of derivatives to the financial system. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 introduced new regulations for derivatives known as swaps. It gave the Commodity Futures Trading Commission (CFTC) regulatory authority over most swaps involving interest rates, commodities, and currencies and the Securities and Exchange Commission (SEC) authority over swaps involving securities, such as stocks and bonds.
According to the SEC, the new rules were "intended to make this market more transparent, efficient and accessible" and represented the first time that "regulators would be able to monitor and oversee the market."
Despite the tightened rules, derivatives remain in wide use today and are one of the most common securities traded in the financial marketplace.
Did Derivatives Cause the Financial Crisis?
The 2007-2008 financial crisis was brought about by many forces, with derivatives, specifically mortgage-backed securities (MBS), playing a major role.
However, even before the mortgage meltdown, "other factors were in play as well," according to the Federal Deposit Insurance Corporation (FDIC). "Financial innovation and deregulation contributed to an environment in which the U.S. and global financial systems became far more concentrated, more interconnected, and, in retrospect, far less stable than in previous decades." That combination of factors, the FDIC says, made the"U.S. financial system more vulnerable to collapse in times of stress."
What Are Mortgage-Backed Securities?
A mortgage-backed security (MBS) is a derivative whose payment stream derives from the mortgage payments that borrowers make on their mortgages. Investors who purchase MBSs receive these payments as the return on their investment without actually holding the mortgages behind them.
What Is a Swap?
A swap is a broad category of derivatives, defined by the Securities and Exchange Commission as "financial contracts in which two counterparties agree to exchange or 'swap' payments with each other as a result of such things as changes in a stock price, interest rate, or commodity price."
The Bottom Line
Derivatives serve a useful purpose in the financial world, but they also pose risks. Warren Buffett, probably more than anyone else, has helped sound the alarm. Regulations enacted in the aftermath of the 2007-2008 financial crisis have aimed to reduce the danger, although Buffett has maintained that the time bomb is still ticking.
