Note to Self: Always listen to Warren Buffett

During my brief stint at Freddie, an occasional question for discussion at lunch was the company's vulnerabilities. I think it is fair to say that those of us who were worker bees wanted to be sure that the taxpayer would never be on the hook for Freddie Mac debt and/or guarantees.

This was 2002 and 2003, so default risk was not a great worry: the company's underwriting practices at the time were sound, and mortgages were protected either by 20 percent downpayments or mortgage insurance, and property values were still rising, but not yet at a bubble like pace in places like Las Vegas and Florida. As for interest rate risk, the company purchased hedges so that its balance sheet would always have duration of less than a month, and so that duration risk was quite small too--although while hedging duration is pretty straightforward, convexity is more complicated (duration is basically the first derivative in how capital value changes with respect to interest rates; convexity is the second derivative). FWIW, I also thought the people who executed risk management at Freddie were very good at their jobs.

In these discussions, we failed to predict the principal reason the company got into trouble: we had no idea that senior management would recklessly gamble the charter through accounting that was both misleading and (it turned out) incompetent. I have arguments with William Poole, but when he said that management risk was a huge problem with having institutions like Fannie and Freddie, he was right.

But one among us (whose name I will reveal if he/she gives me permission to do so) did predict a major source of the current problem: counterparty risk. For example, Freddie Mac would buy instruments called swaptions, which would give the company the option to swap floating rate debt for fixed rate debt, and vice versa. These swaptions would allow Freddie to manage its balance sheet when interest rates changed in the future. Suppose, for instance, Freddie borrowed long-term in order to finance fixed rate mortgages. Now interest rates fall and borrowers refinance. Swaptions allowed Freddie to trade its expensive fixed rate debt into less expensive floating rate debt to match the lower return on its portfolio (and the converse when interest rates rise). But of course, swaptions would be useless if the institution with which Freddie contracted could not make good on its part of the bargain when interest rates changed.

In 2003, Warren Buffett called derivatives (such as swaptions) weapons of mass financial destruction. Like everyone else, I have long admired Buffett, but I though he got this one wrong. Derivatives allowed institutions to hedge and therefore reduce risk! Or at least, I thought this was the purpose of derivatives.

But of course, investors can also use derivatives to speculate, and when they do so (and particularly when they do so using leverage), derivatives become very dangerous. AIG, for instance, guaranteed against mortgage default. This meant that when defaults rose to levels not seen since the Great Depression, it didn't have enough capital to meet its responsibility to its counterparties. So the counterparties who thought they had hedged their risk found themselves exposed, which in turn ate into their capital position, and so a cascade was on.

Derivatives can be used for good, or for evil. Buffett understands human nature far better than I, and I should always remember that.