Carol Loomis has written a “must read” article on derivatives which appears in the July 6 issue of Fortune Magazine as well as online at Fortune.com.  At a time when regulation of derivatives is a major focus in Washington, it is useful to step back and take a deeper look at the events of the past several years to understand the depth of the problem and the complexities awaiting those who would try to reduce the overall level of systemic risk inherent in these complex instruments.  Here are a few excepts and comments from the article along with my views on how investors can manage risks associated with derivatives.

The Case For Regulation

While many have claimed that the cause of derivatives problems at companies such as AIG was management error rather than any systemic problem related to the derivatives instruments, the article presents a different view:

A basic reason for favoring regulation is that derivatives create a kind of mirage. They don’t extinguish risk, they simply transfer it to a different party — a counterparty, as the term goes. The ultimate outcome is millions of contracts and an endless, virtually unmapped, web of connections among financial institutions. That maze exists today, and so does the systemic threat it raises: that some major counterparty will go bust and drag down other institutions to which it is linked.

We came perilously close to such a chain reaction in the past 18 months, as both the economy and the financial system buckled in distress. Derivatives cannot be called the central villain in this drama. That dishonor belongs to some combination of bad management and a real estate world gone crazy. But derivatives elevated the stakes, as they seem constantly to do. Today, as the financial system goes about digging itself out of the muck of trouble, no one imagines that the risks of derivatives have diminished. That’s what the regulatory clamor is all about.

The article goes on to describe how many red flags have been visible for at least fifteen years dating to a 1994 Fortune article also written by Carol Loomis.  The current article describes many of the problems that faced Bear Sterns, Fannie Mae and Freddie Mac, and Lehman Brothers.

Profits for Everyone!

I found the portion of the article dealing with the perverse accounting problems related to derivates particularly important and insightful.  Due to the often opaque characteristics of complex derivative contracts, it was normal and common for each side of such a transaction to book a profit.  This pleasant result has created many problems unwinding the derivatives exposure of major financial institutions because the valuation of a contract is apparently subjective under many circumstances.  The article goes into some detail regarding a peculiar situation involving Lehman, Bank of America, and J.P. Morgan that would be amusing if it did not point to such a serious malfunction of the system.

Move now to the accounting problem. While sometimes the fair value of a derivative can be precisely determined, at other times it must be derived from murky markets and models that leave considerable room for interpretation. That gives the holders of derivatives a lot of bookkeeping discretion, which is troubling because changes in fair value flow through earnings — every day, every quarter, every year — and alter the carrying amounts of receivables and payables on the balance sheet.

The subjectivity involved in derivatives accounting also means that the counterparties in a contract may come up with very different values for it. Indeed, you will be forgiven if you immediately suspect that each party to a derivatives contract could simultaneously claim a gain on it — which should be a mathematical impossibility.

Berkshire Hathaway and Derivatives

Here is an interesting excerpt related to Berkshire Hathaway and the apparent (but incorrect) inconsistency between Warren Buffett’s characterization of derivatives as “weapons of financial mass destruction” and Berkshire’s own position in mispriced derivatives:

…. it is a celebrated fact in the financial world that the man who sparked 1,370,000 Google citations for “financial weapons of mass destruction” has bought a good many of them for Berkshire Hathaway (BRKA, Fortune 500). Explaining, Buffett points out that as far back as 1998 he had told shareholders about derivatives Berkshire owned, and that he never said he wouldn’t again exploit a mispricing when he saw one in a derivative. (It is the opinion of this writer, a friend of both Buffett’s and Munger’s, that Buffett is incapable of ignoring mispricings, wherever in the financial markets they may exist.)

Reform Proposals

The article goes on to discuss some of the initiatives under discussion which would attempt to reduce the systemic risk related to derivatives.  This includes the clearinghouse concept in which derivatives with “standard” features would be cleared on an exchange in an attempt to reduce counter-party risk  as well as discussions underway in Washington to create a regulator with broader authority to deal with systemic risks to the system.  A quote from the article calls into question whether the nature of regulatory agencies can keep up with the ever changing nature of financial innovation on Wall Street:

“It doesn’t matter what they do in Washington,” said a New York derivatives trader recently, showing Wall Street’s all too common contempt for policymakers. “The smart guys who come out of business school don’t take regulatory jobs there. The smart guys go to places where there are chances to do well. And if there are new rules, the smart guys will just deal with them and move ahead.”

Implications for Investors

What’s an investor to do in a system where derivatives could cause new meltdowns at unpredictable times?  There is probably not much that can be done to fully protect against a systemic meltdown.  However, on a micro level, companies should be scrutinized in great detail when it comes to derivatives exposure particularly when it comes to the methodology used to mark derivatives to market.

In my opinion, the opaque characteristics of the mark to market process and the degree to which derivatives can imperil a company that mismanages exposure places most companies with significant derivatives exposure in the “too hard” pile when it comes to evaluating candidates for investment.  I would rather miss some good opportunities than take unquantifiable risks with my capital.  The title of this article may imply that some ideas for managing exposure to companies exposed to derivatives will be proposed, but instead my solution is to simply “punt”.  I think that this is an intelligent solution.  While others may have the ability to deal with this risk, it is outside my circle of competence and I suspect the same is true for the vast majority of investors.