While the final chapter concerning the fallout from the U.S. housing bubble fallout may not be written for years, the bust has already delivered many valuable lessons regarding the residential real estate market. Alas, with fresh memories of financial crisis and dysfunction, some people have suggested that securitization, derivatives, and financial innovation (broadly) were the primary causes of extreme market volatility and ensuing wealth destruction, and thus, must be discouraged or even stopped. Without qualification, such sentiment is myopic and dangerous.

“In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” - Warren Buffet, Berkshire Hathaway 2002 Annual Report

In attempts to sensationalize or bolster their cases, many of today’s harshest critics of derivatives and financial innovation recite a metaphor written by Warren Buffet in Berkshire Hathaway’s 2002 annual report (see inset). Conveniently, these people tend to ignore the fact that The Oracle himself finds productive uses for derivatives. (For example, in April, The New York Times reported that Berkshire Hathaway’s notional exposure to derivatives contracts at the end of 2009 was approximately $63 billion, with corresponding “derivatives liabilities” of $9 billion).

On April 22, President Barack Obama gave a speech at Cooper Union in downtown Manhattan to share his vision for financial reform. He too invoked Buffet’s financial nukes metaphor, but with helpful context (see below).

I found this portion of Obama’s speech mostly constructive. He did raise a few concerns, however. For example, I’m not sure how well-equipped the government will be to define what constitutes “reckless risk taking”. How does one draw a bright line between “reckless risk taking” and legitimate speculation? Also, the “invisible to regulators” remark was puzzling. The largest players in OTC derivatives markets are bank-owned broker-dealers regulated by the SEC and The Federal Reserve. How could these $600 trillion+ (albeit, notional) markets possibly be “invisible” to them? Perhaps regulators were lacking in effective and timely rule-making resources, enforcement capacity, or were simply observers with eyes wide shut. The notion that OTC markets were somehow hidden, or that regulated banks’ derivatives trading activities were impossible to inspect and scrutinize is not credible. Like others who have used Buffet’s colorful “financial weapons of mass destruction” sound bite, Obama did not cite the sentence that immediately preceded the nukes metaphor in the same 2002 Berkshire Hathaway annual report:

“Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.” Of course, this line would not have fit very neatly into President Obama’s Cooper Union speech, an address that The White House titled “Remarks by the President on Wall Street Reform”. In late April of this year at Berkshire Hathaway’s annual shareholder meeting, Charlie Munger, Warren Buffet’s business partner, echoed The Oracle’s 2002 concerns about an ineffective regulatory apparatus for OTC derivatives contracts. Munger went further than Buffet however, blaming regulators - not bankers - for fallout from the financial “nuclear weapons”. He said, “When the tiger gets out and starts creating a lot of damage it is insane to blame the tiger. It is that idiot tiger keeper that … caused the problem and our solution is not to just beat the tiger but efforts to improve the tiger keeper.”

Munger’s logic suggests that, in examining the fallout from the U.S. housing bust and the meltdown in the subprime mortgage credit and derivatives markets, the actual enablers of GSE mission creep and other root causes of home price volatility and outsized growth in the subprime mortgage hydra warrant much closer scrutiny.