Warren Buffett Admits To Manufacturing Weapons Of Mass Destruction

"Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."—Warren Buffett
Back in the early days of this century, Warren Buffett faced a rare—although not as rare as some believe—financial setback and public relations disaster when Berkshire Hathaway was forced to shutter its General Reinsurance securities unit, which it had purchased for $22 billion only a few years earlier. The Berkshire-owned company found itself caught up in the financial and accounting scandals, with its business facing serious losses and its executives under investigation by the SEC and facing numerous criminal prosecutions. Even after the company shut it down, General Re, which was a major derivatives dealer, was stuck with 14,384 outstanding contracts with 672 counterparties outstanding, with billions of dollars on the line. Buffett’s personal fortune fell by $5 billion to $30 billion, reducing him to rank of “second richest person” behind Bill Gates.
Right around that time, Buffett publicly turned against derivatives. "When Charlie [Munger,] and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is taking," he told investors.
But not understanding derivatives and publicly attacking their role in global finance hasn’t stopped Berkshire Hathaway from selling derivative contracts on stock indexes and bonds. This year the company has collected premiums of about $2.5 billion from these derivatives, according to a report in the Wall Street Journal. Buffett once compared being the derivatives business to being in Hell. And, apparently, he likes it there.
Is this rank hypocrisy? Perhaps it depends on what your definition of derivatives is. From the Wall Street Journal article, it’s hard to tell what exactly Berkshire Hathaway has been selling. But it sure sounds like credit derivative swaps. Those derivatives, of course, are part of what fueled investor’s ravenous appetite for corporate debt—at least until the recent credit crunch. It was often said that these derivatives weren’t making the world a riskier place but helping diversify risk—although that assessment in now undergoing a general re-assessment. And these are often considered some of the riskiest types of derivative products on the market.
The lesson seems to be: Watch what they do, not what they say. Especially if they say it in a folksy Midwest way.
Buffett Scores With Derivatives [Wall Street Journal]