Warren Buffett calls derivatives “financial weapons of mass destruction.”  Do you believe him?

Derivatives are financial instruments whose prices are derived from underlying assets.  One example would be a futures contract between a farmer and a food processor.  In this case the underlying asset is the grain harvested by the farmer and the derivative is the contract to deliver that grain at a specified price, time, and location.

This all sounds reasonable enough.  So why would Warren Buffett call derivatives “financial weapons of mass destruction”?

What if a Wall Street trader could make financial bets that rewarded the trader with bonuses and the firm with earnings all without setting aside capital or assets to cover that bet?  How many of those bets would you make?  How many would you make when you get immediately rewarded for wins and little or no apparent penalty for losses in the unforeseeable future?  Finally, how many would you make when your expert with a PhD from MIT says his mathematical model shows those bets are risk free?

Now that you’ve thought about those questions, watch this video from Khan Academy regarding Credit Default Swaps (CDS).   Listen for the part about a cascading failure which starts in one location and ripples through the whole system, ultimately destroying everything that looked seemingly safe and sound.

Khan Academy – Credit Default Swaps 2