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Monday, Aug. 20, 2007

Know that the devil is in the derivative

LOS ANGELES — Although Warren Buffet does have — I reluctantly admit — more money than I do (like maybe $50 or so billion more?), we do share a pair of common traits. The first is that this internationally famous investment banker (known as the "Sage of Omaha") tends to favor cautious, carefully considered kinds of investments. So do I.

But my caution is more like investment laziness: I prefer not to have to worry about what my money is doing when I am trying awfully hard to do a decent job as a professor, a columnist, a husband and a book writer.

Sure, if I had absolutely nothing better to do with my time than to worry about money 24 hours a day, seven days a week, I might be a lot less lazy about how I invest what little I have — and then I might have a lot more to invest, right? Or — with the way the markets have been misbehaving lately — I might just as well wind up with less, a lot less.

The second commonality between Warren and me is that we both abhor newfangled financial investments known generically as derivatives.

And derivatives — or at least some significant fraction of the $100 trillion of them out their in world markets — appear to be at the center of the current world market turbulence.

Derivatives (defined, in short, as contracts whose values are based on the performance of underlying investments) first caught my attention during the Asian Financial Crisis some 10 years ago. Predatory speculative Western funds prowled Asia looking for national currencies and equity markets to attack for profit. They wound up sucking a lot of money out of places like Thailand, South Korea and Indonesia.

The effect on some Asian economies was so devastating that a strong poisonous bias on my part tends to surface with the mere mention of terms like hedge funds and derivatives, which are associated with large Western speculative funds. I openly admit to that bias.

Buffet's antipathetic reservations about them would however appear to derive from his caution, not from concern for others. Buffet knocks them because of worries about their intense opacity (they are by nature deeply secretive investment constructs) and their endless complexity (structured mainly by computer models of dense design).

The sage minces no words. Derivatives, he said a few years ago, are "financial weapons of mass destruction. We view them as time bombs both for the parties that deal with them and the economic system-carrying dangers that, while now latent, are potentially lethal."

Devised by "madmen," he said, they remind him of "hell" as they are "easy to enter but hard to exit." Because of their endless complexity, they lack transparency, are fiendishly difficult to monitor and regulate, and thus are ideal for conspiracies of "huge-scale fraud."

The current market spasms may calm down over time, and maybe the worst of the jitters really is over. But the time of reckoning for derivatives and hedge funds may not be long away. In recent days many hedge-fund returns have plummeted, for particular reasons that escape the managers.

In general, though, the reasons should be obvious: Investment schemes are overly modeled and the investments themselves are overly leveraged. The computer programs that drive the investment strategies cannot always reflect fast-moving market realities. At the same time, too many investments are backed by too much borrowing.

The result is a major mess. These investments are as nontransparent as a deep swamp — sticky, scary and seemingly bottomless. The easy-in/hard-out metaphor of Buffet seems very apt indeed.

One hates to intone a doomsday dirge for fear of fostering a self-fulfilling prophecy. But in all fairness, some of us have been raising alarms about these potential black holes in the international financial system for a decade now. To some of us, it seemed only a matter of time before a Big Bang occurred.

The initial trigger for the turmoil in the current world market was undoubtedly failure at the lower end of the U.S. mortgage market. But as that shock wave worked its way through the international system, it unmasked weak links elsewhere. No one knows whether the system will unravel entirely, or whether the damage can be contained.

Perish the thought of the one event that would surely lead to derivative and hedge-fund reform occurring — that is, a total world market meltdown.

UCLA adjunct professor Tom Plate is a veteran journalist and author of the new book "Confessions of an American Media Man."

Copyright 2007 Tom Plate

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