RodgerRafter's Investing Journal
Derivatives and the Creation of Imagined Wealth

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By RodgerRafter
March 8, 2006

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Warren Buffett gave an inside view into the in derivatives world in his latest letter to Berkshire Hathaway shareholders, and it confirms many things I had already concluded about how derivatives are used to mislead shareholders and creditors about earnings and balance sheets.

Fuzzy derivative accounting is used to overstate profits. Many derivative products allow companies to boost short-term profits while undertaking (and understating) large long-term risks. Traders and CFOs make themselves look better by making overly generous estimates as to how derivatives will perform. On top of all of this is the risk that many counter-parties will simply default when the system is stressed and it finally comes time to make payments on the more extreme derivative bets.

The entire letter is here. The section on derivatives starts on page 9. Here are some highlights:

We lost $104 million pre-tax last year in our continuing attempt to exit Gen Re's derivative operation. Our aggregate losses since we began this endeavor total $404 million...

Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for "imagination" when traders are estimating their value. Small wonder that traders promote them...

A given contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences � and I'm personally familiar with several that were huge � tend to be tilted in a direction favoring higher earnings at each firm. It's a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable...

In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted...

Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner...

It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures...

The derivatives markets have grown tremendously in recent years, and much of the growth in corporate profits has been the result of imagined derivatives related gains. Mortgage lenders and the GSEs book huge profits on their loan sales, imagining that their derivative bets have accurately hedged them against almost every outcome. They also manipulate their mark-to-market values on quarterly basis to meet or beat estimates. All of this is highly suspicious. Valuation differences, as Buffett says, tend to be tilted in a direction favoring higher earnings.

Berkshire spent years unwinding their positions, and eventually ended up admitting they were overstated by $404 million. This is just a tiny percentage of the total overstated positions on company balance sheets. And derivatives are just one tool used in overstating profits while understating risk. Financial institutions have become especially aggressive in their accounting for potential loan losses, as they depend on recent history for their models, rather than considering the true systemic risk.

In a similar way, the rapidly growing Credit Default Swap markets have allowed companies to overstate profits on both sides of most trades. Selling imaginary insurance policies on bonds through the CDS market has been an easy short-term profit maker for hedge funds and large underwriters. They've taken on large amounts of risk but have been protected against rising interest rates and defaults by rapidly expanding credit and an over-stimulated economy. Meanwhile, investors in high-risk securities have been able to claim that their positions are safe through the use of CDS insurance. The systemic risk is that CDS securities are only as good as the trader or firm who writes them. If (when) a credit market event or an economic downturn results in many defaults, the imagined wealth of the CDS writers will come crashing back down to size. If CDS writers are unable to make good on their promises, then the CDS purchasers will also see their imagined wealth wiped out.

In addition to enabling the creation of imagined wealth on both sides of almost every trade, the CDS market has created reckless demand for the underling bonds and has pushed down yields across the bond spectrum. As the economy slows or falters, rising defaults should put pressure on the CDS market, which in turn should lead to rising interest rates, tightening credit and more defaults.

As real wealth leaves the country at roughly $1 Trillion per year and debt service to foreigners continues to mount, the net profitability of corporate America has depended ever more on a web of lies and accounting fraud. The Fed has taken as much volatility out of the market as was necessary to keep the Ponzi schemes from unraveling to date, but the question remains as to how long this can go on. Eventually America will wake up to realize that its wealth is gone (transferred into the hands of wealthy foreigners and corporate executives). All that remains of many of America's great financial corporations is just a glittering shell, as real assets have been rotting away at the core.

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