FCIC Interview With Warren Buffett On Derivatives, Financial Crisis

The Financial Crisis Inquiry Position interviewed billionaire investors, hedge fund managers and executives at financial institutions on the cause of the financial crisis. This post is on the interview with Warren Buffett. Find all of the interviews here and the full FCIC report. I'll do an in depth post on John Paulson's interview later, whose firm made $12 billion shorting the subprime mortgage market.

Buffett said leverage at Lehman Brothers (and other banks), fueled by derivatives, was the major systemic risk (1:07). He mentioned that netting arrangements between Lehman Brothers and Bank of America (and JP Morgan, the counterparty for BAC) had major swings before Lehman went broke (1:07:30). And lets not forget the CDS chart on AIG, which was writing CDS without capital. Then Buffett got into the good stuff on derivatives and transparency. These quotes are not from an official transcript. Listen to the full interview MP3 at FCIC.gov.
"It started out with the simple ones, interest rate swaps and foreign currency.. and then the profit got driven away from those.."

"Then the plain vanilla contracts, there weren't any money in it because they were on the screens (price transparency?). But what they called sometimes the toxic waste, there was a lot of money in...." (*an example he gave was Procter & Gamble vs. Bankers Trust, see below*).

"There's just more money in contracts that people don't understand, and so then you get the proliferation of these things. And who knows what's in the mind of the end user of these things (example: Jefferson County, Alabama swap blowup, Bond Buyer, Bloomberg). It's an instrument that is prone to lots of mischief.."

Read: Procter & Gamble's Tale of Derivatives Woe (1994) - nice quote from George Soros
"As Mr. Soros himself conceded Wednesday in Congressional testimony on derivatives, "the risks involved are not always fully understood even by sophisticated investors, and I am one of them."

And this was funny.
"The lesson for those who don't has long been clear. In a speech in December, William J. McDonough, president of the Federal Reserve Bank of New York, warned that top managements of financial and nonfinancial companies have a responsibility to understand and constantly monitor derivative markets when their companies are involved in them."

"It's Nov. 2, 1993, and two employees of Bankers Trust Co. are discussing a leveraged derivative deal the bank had recently sold to Procter & Gamble Co. ``They would never know. They would never be able to know how much money was taken out of that,'' says one employee, referring to the huge profits the bank stood to make on the transaction. ``Never, no way, no way,'' replies her colleague. ``That's the beauty of Bankers Trust.''"

It looks like from 1980-2007 it was a circus in banking with no regulation and transparency. It was the start of the 30-year structural leverage boom. First the savings & loans junk bond scandal, then interest rate swap blow ups, and finally loan securitizations, CDOs and credit derivatives. BOOM!

This is an interesting article regarding OTC derivatives: "SPECIAL REPORT-In derivatives trade, RIP OTC?" (Reuters). How do you put standardized OTC derivatives on electronic exchanges.

Notional Amount and Gross Market Value of OTC Derivates Outstanding
Source: FCIC

UPDATE: I was able to embed the MP3