The Notional Value of Ignorance

“We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” –Warren Buffett

Much has been made of the Oracle of Omaha in my office as of late. (Full disclosure: My firm currently represents Alice Schroeder, author of the authorized Buffett biography, The Snowball.) And much has been made of his “investments” into Goldman Sachs and GE. Some have deemed his tactics mercenary. Most of my team thinks he’s being an opportunistic corporate citizen, albeit at a very comfortable return of 10%.

But at issue today is not what Mr. Buffett has done in the past few weeks, but what he stated in the quote above…six years ago. Oracle, indeed! It has been pointed out to me that this quote has resurfaced in a number of recent media reports including this October 9th piece from the NY Times.

The Investor Relations team that I run at CJP Communications in New York has been on the phone almost non-stop for the last six weeks consulting with analysts, investors and economists trying to call a “bottom” to the market and helping our clients to understand where they fit in this new world order. What we have heard over the last few days is beginning to lead us to one single conclusion:

Unless there is an immediate, global, and coordinated effort to centralize the trading, clearing and settlement of these long-term derivatives contracts, this crisis will get considerably worse before it gets better.

To wit: depending on whom you ask, there are hundreds of trillions (yup, that’s with a “tr”) of these contracts still floating about out there, buckets of them offshore, and many of them not readily “quantifiable.” As one member of our team pointed out, while a centralized trading platform is necessary, centralized valuation is the first step…classic “chicken-or-the-egg” argument. But that is another post for another day.

For the sake of argument, even if you assume that the gross market values (i.e. the more accurate measure of the market financial risk of these instruments) is closer to $20-25 trillion (and again, depending on who you ask), this dwarfs the current “rescue packages” by a factor of 20. And the effect of that investment to date has been minimal at best.

With the global wheels of credit essentially locked, what the world needs now is a lot of grease, not another multi-trillion dollar problem. But while the banks continue not to lend to each other, mirroring the fear of investors fleeing the capital markets, our fear is that inaction will lead to further paralysis, and that the real crisis, one that has not even arrived, could lead to a catastrophic global collapse.

In speaking with one investor yesterday, he likened it to “…standing with your back to the ocean with the tsunami sneaking up from behind.” Mr. Buffett was right in 2002–what was once latent has now become lethal. And if he’s got a solution, we should gladly pay him 10% for his time and talent, especially if he has a solution.