The Weapons of Financial Mass Destruction Are Still Primed

In his 2002 Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) Shareholders Letter, Warren Buffett famously labeled derivatives weapons of financial mass destruction. Six years and one financial crisis later, those weapons are still active, and their stockpiles are more heavily concentrated than before the crisis thanks to the vanishing of Bear Stearns and Lehman Brothers. According to a recent IMF working paper, the five big arsenals are:

 

Counterparty Liabilities (March 2009)

Year-on-Year Growth

Goldman Sachs (NYSE: GS  )

$91 billion

(13%)

JPMorgan (NYSE: JPM  )

$86 billion

26%

Bank of America (NYSE: BAC  ) / Merrill Lynch

$77 billion

(13%)

Morgan Stanley (NYSE: MS  )

$54 billion

(22%)

Citigroup

$81 billion

(36%)

Total

$389 billion

(15%)

Source: IMF Working Paper, Counterparty Risk, Impact on Collateral Flows and Role for Central Counterparties, August 2009.

The "counterparty liabilities" figure for each company represents the amount owed to all its trading counterparties on over-the-counter (OTC) derivatives after accounting for netting agreements and assigned collateral. In other words, the International Monetary Fund has quantified the risk to the financial system if any of the five major players in the derivatives market were to fail, and it's clear from their figures that systemic risk is alive and well.

Winners and losers
The table shows that the crisis has damaged Citigroup's derivatives franchise, forcing a massive 86% reduction in its net counterparty exposure -- market participants are concerned about having Citi on the other side of their trades. Meanwhile, Goldman Sachs (NYSE: GS  ) has emerged a winner, as it is the only bank that has gained share without the benefit of a merger.

Less profitable for banks, less risk for taxpayers
The credit crisis has shown that the amount of capital supporting OTC derivatives trades is inadequate. Whether some of these products migrate to a single clearing platform (which could be a boon for exchange operators such as CME (Nasdaq: CME  ) ), or regulators impose higher capital requirements on OTC trades, we should expect the leverage -- and the profitability -- of these products to fall. That would be all to the good, as such measures are critical if we are to avoid simply replacing a system of "too-big-to-fail" with one of "too-bigger-to-fail."

Goldman is a great business, but its profits accrue mainly to its employees, not its shareholders. Morgan Housel has identified three high-quality businesses that are still cheap -- and more shareholder-friendly.

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Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Berkshire Hathaway is a Motley Fool Stock Advisor and Motley Fool Inside Value recommendation. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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