It would be helpful if he would actually explain how this meltdown would occur, rather than just yelling about how crazy terrible it will be. I personally know little about derivatives and how they work, other than they seem to be a way to securitize a bet on a non-equity occurrence ... like the Giants winning the Superbowl or a storm killing the Florida orange crop.
I agree with this statement and will make an additional comment.
I wonder to what extent Warren Buffett's treatment as a oracle by the financial press creates a non-helpful feedback loop where complex financial activities that can't be reduced to simple homilies (i.e., buy low, sell high) are immediately viewed as inevitably catastrophic and diabolical.
I say this with particular focus on the notion, which is once again stated in this article, that if Buffett doesn't understand it, who does? Apparently, a whole lot of very very smart people understand these systems (exotic financial instruments, electronic trading systems) enough to make them a significant part of the modern economic structure. Certainly, there is something more complex and nuanced going on here but you would not know it from the way the press (via Buffett) is presenting it.
As far as I can tell, this entire article was based on two sentences in Buffett's letter to shareholders six years ago. Buffett is obviously a financial genius, but it isn't very easy to see exactly what he meant from these two sentences. Basing two entire pages of doom and gloom on that with nothing but arbitrary statistics to back up the point doesn't seem very trustworthy to me. If the author is serious that there is a massive bubble flying under the radar, he's not making a particurlary solid argument.
Headlining this story 'Warren Buffet: *' is very misleading. Please don't.
Actually Buffett has pretty much been shouting this from the rooftops. In 2003 he even spoke at length about this at my school. So the "Warren Buffet.." part is not misleading. However I don't think the 16 trillion number came from Buffett, so I think linking the two is misleading
I don't know if the article's right or not, but...
I couldn't get over the figure...$516 trillion is...a lot of money. I thought the total wealth was closer to $125 trillion...wow. Of course, there are issues with how you count this money, and whether it's real or not, but, damn, 516 trillion...that's almost a quadrillion.
516,000,000,000,000.
5.16 x 10^14
Damn.
Of course, I'm sure we'd all give a quadrillion quadrillion for two seconds of joy.
The way they get that number is something like this: imagine a small economy with one oil well, one gas station, and one commuter, and one speculator. The oil well owner pre-sells $1000 worth of oil to the gas station (that's $1000 in notional derivative value). The gas station owner pre-sells the same amount of oil to the commuter (that's another $1000). The commuter decides he'd rather walk, after all, and sells the same value of oil to the speculator ($1000). The speculator decides he'd rather play the soybean market anyway, and looks for someone who wants to trade oil. Alas, the only person who feels good about oil is the oil well owner, who is willing to buy $1000 worth of oil from the speculator.
Since nobody has canceled any of their speculative contracts, the notional value of the derivatives is the sum of the value of all of the trades: $5000. And yet, all but one of the participants made a positive bet (buying $1000 worth of oil) followed by an exactly-offsetting negative bet (selling the same amount of oil). So they all net out to zero, except the oil-well owner; we're all back where we started.
The problem is credit risk. If the gas station is destroyed in an earthquake, the commuter may not be able to collect on his bet with the station owner, and may thus be unable to pay the speculator, who may thus be unable to pay the oil well owner, forcing everyone to cut their spending or possibly even default. But in this case, it takes an outside catalyst, and the problem is not the derivatives themselves. The problem is credit risk. Also, earthquakes.
My own understanding of derivatives is very weak, but could someone extend this example to explain what the resulting state would be in this chain? Simplifying a little, a->b->c->a (a loop), where -> is "owes $1000". So party A dies, leaving B in the hole, right? This seems like a recipe for massive implosion, an unstable system ala a mountain of sand. Destabilize one grain, somewhere, and you get an avalanche.
It depends. When Party A started talking to his broker about getting into the derivatives market, his broker might have said "And what do you do in the event that you're solvent, but dead?" And Party A would get in touch with his lawyer, and see to it that in the event of his death, his assets were liquidated and his debts repaid. Sure, it sounds tenuous. On the other hand, our financial system has the same risk -- without the finance -- because we rely on people to do things in the future that they may not be able to do. Imagine a similar market, but without the derivatives: one guy commissions someone to paint his portrait over the next year, the portrait-painter uses the portrait-money he's getting to pay someone to fix up his house, the house-fixer pays to give his kid piano lessons, etc. Again, a single death or default can break the chain, and the 'notional value' here is the value of all future promises made by all parties -- could be larger than the GDP, though the notional value won't get too high unless you have multiple layers of subcontractors.
Any time people get comfortable making a promise they can only keep if promises to them are kept, you will be able to calculate a scary notional value for these promises, and argue that we're all betting with vastly more than we own. But everyone who makes a promise -- whether to pay $80 for a barrel of oil next June or to finish debugging next week -- implicitly accepts that there is a chance of default, and expects their counterparties to factor this in.
Somehow, despite giant chains of subcontracted promises, our economy has survived. I think it will keep surviving. I think derivatives are not so much a new promises as a way to formalize promises. We might be making more promises than we used to, but we're probably just measuring them better.
