Dan Sweet

Warren Buffett on derivatives (11 of 12)

This is the eleventh in a series of twelve posts. The introduction to the series is here. By way of review, these are my notes of Warren Buffett’s responses to questions from Notre Dame and Stanford MBAs on October 9. 2007.

How do you feel about derivatives?

Derivatives create big positions people don’t understand.

Classic case is detailed in the Brady Report from October 19, 1987.  130/30 is the new hot thing.  Portfolio insurance was the thing then.  “Dynamic Hedging”  Basically the lower it goes the more you should sell.  Institutions had to sell at certain levels and everyone knew it.  Less than 2% of the market was on this kind of auto-pilot program-yet crashed the whole market.  Derivatives have created huge amounts of capital that are forced to move automatically.

They offer opportunity to me but a lot of people can get hurt.

A greater portion of the market is poised on a hair trigger to respond to given messages.

Federal Reserve margin requirements are 50% for you and me.  So many ways around that. “total return swap” for example.  Long Term Capital Management had a $6 billion position with no capital put up.  Whatever happens in the market is exacerbated by derivatives.

Banker’s Trust screwing P&G—like 8 variables those companies didn’t understand.

We will make a lot on derivatives but I will know every position.

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