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I can assure you that the marking errors in the derivatives business have not been symmetrical.
Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the
CEO who wanted to report impressive "earnings" (or both). The bonuses were paid, and the CEO profited
from his options. Only much later did shareholders learn that the reported earnings were a sham.(page 13)
One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate
100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts
up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a
future date it will receive any gain or pay any loss that the bank realizes.
Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of
derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the
risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and
analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with
derivatives contracts. When Charlie 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
running.(page 14)
- Warren Buffet in his letter to Berkshire shareholders for 2002. Full document in PDF
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