May 9, 2003 By Martin Crutsinger Ap Economics Writer 4 min read

WASHINGTON (AP) – Federal Reserve Chairman Alan Greenspan, taking issue with the warnings of billionaire investor Warren Buffett, said Thursday that the growing use of complex financial instruments known as derivatives does not pose a threat to the country’s financial system. Greenspan said that financial market participants who purchased derivatives, including banks, had been able to spread their risks and this had helped to lessen the severity of the 2001 recession.

“Even the largest corporate defaults in history – WorldCom and Enron – and the largest sovereign default in history – Argentina – have not significantly impaired the capital of any major financial intermediary,” Greenspan said in remarks delivered by satellite to a banking conference in Chicago.

“The benefits of derivatives, in my judgment, have far exceeded their costs,” Greenspan said.

Greenspan used his speech as a rebuttal to warnings about the use of derivatives issued by Buffett, the president of Berkshire Hathaway Inc., in March in his annual letter to shareholders.

In this year’s letter, Buffet contended that derivatives were “financial weapons of mass destruction” saying that they posed grave risks to the financial system.

Derivatives essentially are contracts whose value depends on an underlying asset such as the value of a currency or a bushel of wheat. They have soared in popularity in recent years, with one estimate putting the total value of all unregulated derivatives at $127 trillion, up from $3 trillion in 1990.

Trading in simple derivatives, such as a futures contract on grain which locks in a particular price at some date in the future, are regulated by the Commodity Futures Trading Commission.

However, more complex derivatives which are used by banks and hedge funds to spread risks are essentially unregulated. They have played a key role in several major financial crises in recent years, ranging from the collapse of Barings Bank in Britain in 1995 to the near-collapse of New England hedge fund Long-Term Capital Management during the 1998 currency crisis and the collapse of Houston-based Enron in 2001.

In his speech, Greenspan acknowledged the role that derivatives played at Barings and Long-Term Capital, but said overall losses to banks from their derivative operations have been small.

While Greenspan said he did see some problems in the use of derivatives, he warned against increased government regulation in this area.

He said the flaws that exist in the largely unregulated over-the-counter derivatives market were best dealt with by the participants themselves, generally sophisticated investors such as banks and large hedge funds. Like Buffet, Greenspan said he was concerned about the growing concentration of derivatives in certain markets in the hands of a few dealers. If one of those dealers got in trouble, it could affect the operation of the entire market, he said.

But Greenspan said threats such as this could be more properly managed by participants in those markets making moves to hedge against such a risk rather than imposing government regulations, which Greenspan said could end up just giving market participants a false sense of security. In answer to questions, Greenspan repeated his call for corporations to treat lucrative stock options as a business expense. In the failure of Enron, company executives reaped millions of dollars in profits by cashing in their stock options before the company’s share price plummeted.

Greenspan said that the argument raised by opponents of expensing options – that you cannot properly assign a value to stock options – was just “flat wrong.” He noted that the Financial Accounting Standards Board is examining a number of technical issues surrounding possible rules on the expensing of stock options.

So far, companies that trade in complex derivatives have thwarted all efforts to impose more regulations. Sen. Dianne Feinstein, D-Calif., is sponsoring legislation to regulate energy derivatives because of her belief that Enron used them to manipulate prices during the California energy crisis.

Buffet has argued that the basically unregulated derivatives market represents “time bombs, both for the parties that deal in them and the economic system” because large amounts of risk, particular risks on various types of loans, “have become concentrated in the hands of relatively few derivatives dealers. … The troubles of one could quickly infect the others.”