The 300 Trillion Time Bomb

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The General Re unit started out with more than 23,000 trades worth just under $1 trillion. The losses from excising those trades accounted for about half of Gen Re’s total loss. But even that overstates the story. In ditching the portfolio, Gen Re ended up making a modest amount on most contracts. It was a mere 500 trades that accounted for more than $200 million of the losses. The toxic 500 fell largely into one basket: complex foreign-exchange agreements. These were often contracts that spanned periods of 30 years or more and involved bets on both interest rates and multiple currencies. For example, Gen Re brought together Japanese retailers (who had become fed up with low returns in their local market) with all sorts of lending agencies, such as the World Bank. Gen Re hedged those trades with offsetting contracts pegged to moves in interest rates and currencies over several years. But because of what was essentially a math error, the hedges were inadequate.

Gen Re quickly learned that even without math mistakes, the squirrelly real world can throw off a sound financial model. In one set of trades, Gen Re figured it had found a bit of treasure. It entered into contracts involving the U.S. dollar, using what’s called a Bermudan swap option. These contracts were theoretically worth more than another common option because an investor could get out of them at multiple points in the future rather than at a single fixed date.

That’s the theory, anyway. When Gen Re went to unwind its trades, it couldn’t capture the extra value that its Bermudan swap options were supposed to have. “The models we used were simply models,” says Nelson. “They didn’t take into account real-life situations.”

The accounting for derivatives lends itself to bad numbers, even in the absence of malfeasance or sloppiness. At one point, Brandon reviewed the derivatives unit’s business over the past 10 years. During that period, it recorded about $1.2 billion in trading revenue and $505 million in operating income before taxes. It also set aside reserves in case things went badly. Gen Re’s auditors even wondered if the division was putting too much aside. But its reserves turned out to be insufficient. In Brandon’s analysis, the unit generated a third less income than had been anticipated. How did it go so wrong? Profit estimates for derivatives are susceptible to overstatement, in part because many of the contracts extend years into the future.

The irony (or perhaps hypocrisy) is that Buffett still uses derivatives. His famous declaration was “a lovely phrase, and it got him more ink than he could ever have hoped for or imagined,” says Jim Grant, who edits Grant’s Interest Rate Observer. “But to judge by his own investment record, he didn’t take himself literally. Nor should we take it literally. Credit default swaps and other derivatives are neither inherently good nor bad but desirable or undesirable at a price.”

Grant gets support for this theory from an authoritative source: Buffett himself. In a recent letter, released in early March, he wrote about the derivatives Berkshire Hathaway has entered into. “Why, you may wonder, are we fooling around with such potentially toxic material?” His answer: “Derivatives, just like stocks and bonds, are sometimes wildly mispriced.”

There you have it. There’s nothing intrinsically scary about derivatives, except when the bad 2 percent blow up. Derivatives are vulnerable to problems because the accounting is complex and they can add much more leverage to the system than investors realize. For derivatives to become dangerous, they need complacency.

That’s exactly what’s going on today. In February, a presidential panel led by Treasury Secretary Henry Paulson said hedge funds—among the heaviest users of derivatives—should remain lightly regulated. And the European Union’s chief market regulator similarly declared that no extra private equity regulations were needed. So, sure, derivatives aren’t inherently evil. But in the hands of overmatched regulators and blithe investors, they will be.

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