The goose is cooked

ARROYO GRANDE, Calif. (MarketWatch) -- "Charlie and I believe Berkshire should be a fortress of financial strength" wrote Warren Buffett. That was five years before the subprime-credit meltdown.

"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."

That warning was in Buffett's 2002 letter to Berkshire shareholders. He saw a future that many others chose to ignore. The Iraq war build-up was at a fever-pitch. The imagery of WMDs and a mushroom cloud fresh in his mind.

Also fresh on Buffett's mind: His acquisition of General Re four years earlier, about the time the Long-Term Capital Management hedge fund almost killed the global monetary system. How? This is crucial: LTCM nearly killed the system with a relatively small $5 billion trading loss. Peanuts compared with the hundreds of billions of dollars of subprime-credit write-offs now making Wall Street's big shots look like amateurs.

Buffett tried to sell off Gen Re's derivatives group. No buyers. Unwinding it was costly, but led to his warning that derivatives are a "financial weapon of mass destruction." That was 2002.

Derivatives bubble explodes five times bigger in five years

Wall Street didn't listen to Buffett. Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007. The new derivatives bubble was fueled by five key economic and political trends:

1. Sarbanes-Oxley increased corporate disclosures and government oversight
2. Federal Reserve's cheap money policies created the subprime-housing boom
3. War budgets burdened the U.S. Treasury and future entitlements programs
4. Trade deficits with China and others destroyed the value of the U.S. dollar
5. Oil and commodity rich nations demanding equity payments rather than debt

In short, despite Buffett's clear warnings, a massive new derivatives bubble is driving the domestic and global economies, a bubble that continues growing today parallel with the subprime-credit meltdown triggering a bear-recession.

Data on the five-fold growth of derivatives to $516 trillion in five years comes from the most recent survey by the Bank of International Settlements, the world's clearinghouse for central banks in Basel, Switzerland. The BIS is like the cashier's window at a racetrack or casino, where you'd place a bet or cash in chips, except on a massive scale: BIS is where the U.S. settles trade imbalances with Saudi Arabia for all that oil we guzzle and gives China IOUs for the tainted drugs and lead-based toys we buy.

To grasp how significant this five-fold bubble increase is, let's put that $516 trillion in the context of some other domestic and international monetary data:

• U.S. annual gross domestic product is about $15 trillion
• U.S. money supply is also about $15 trillion
• Current proposed U.S. federal budget is $3 trillion
• U.S. government's maximum legal debt is $9 trillion
• U.S. mutual fund companies manage about $12 trillion
• World's GDPs for all nations is approximately $50 trillion
• Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
• Total value of the world's real estate is estimated at about $75 trillion
• Total value of world's stock and bond markets is more than $100 trillion
• BIS valuation of world's derivatives back in 2002 was about $100 trillion
• BIS 2007 valuation of the world's derivatives is now a whopping $516 trillion

Moreover, the folks at BIS tell me their estimate of $516 trillion only includes "transactions in which a major private dealer (bank) is involved on at least one side of the transaction," but doesn't include private deals between two "non-reporting entities." They did, however, add that their reporting central banks estimate that the coverage of the survey is around 95% on average.

Also, keep in mind that while the $516 trillion "notional" value (maximum in case of a meltdown) of the deals is a good measure of the market's size, the 2007 BIS study notes that the $11 trillion "gross market values provides a more accurate measure of the scale of financial risk transfer taking place in derivatives markets."

Bubbles, domino effects and the 'bad 2%'

However, while that may be true as far as the parties to an individual deal, there are broader risks to the world's economies. Remember back in 1998 when LTCM's little $5 billion loss nearly brought down the world's banking system. That "domino effect" is now repeating many times over, straining the world's monetary, economic and political system as the subprime housing mess metastasizes, taking the U.S. stock market and the world economy down with it.

This cascading "domino effect" was brilliantly described in "The $300 Trillion Time Bomb: If Buffett can't figure out derivatives, can anybody?" published early last year in Portfolio magazine, a couple months before the subprime meltdown. Columnist Jesse Eisinger's $300 trillion figure came from an earlier study of the derivatives market as it was growing from $100 trillion to $516 trillion over five years. Eisinger concluded:

"There's nothing intrinsically scary about derivatives, except when the bad 2% blow up." Unfortunately, that "bad 2%" did blow up a few months afterwards, even as Bernanke and Paulson were assuring America that the subprime mess was "contained."

Bottom line: Little things leverage a heck of a big wallop. It only takes a little spark from a "bad 2% deal" to ignite this $516 trillion weapon of mass destruction. Think of this entire unregulated derivatives market like an unsecured, unpredictable nuclear bomb in a Pakistan stockpile. It's only a matter of time.

World's newest and biggest 'black market'

The fact is, derivatives have become the world's biggest "black market," exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today's slowdown, plus a volatile global market, Wall Street knows derivatives remain a lucrative business.

Recently Pimco's bond fund king Bill Gross said "What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August." In short, not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of America's leaders can't "figure out" the world's $516 trillion derivatives.

Why? Gross says we are creating a new "shadow banking system." Derivatives are now not just risk management tools. As Gross and others see it, the real problem is that derivatives are now a new way of creating money outside the normal central bank liquidity rules. How? Because they're private contracts between two companies or institutions.

BIS is primarily a records-keeper, a toothless tiger that merely collects data giving a legitimacy and false sense of security to this chaotic "shadow banking system" that has become the world's biggest "black market."

That's crucial, folks. Why? Because central banks require reserves like stock brokers require margins, something backing up the transaction. Derivatives don't. They're not "real money." They're paper promises closer to "Monopoly" money than real U.S. dollars.

And it takes place outside normal business channels, out there in the "free market." That's the wonderful world of derivatives, and it's creating a massive bubble that could soon implode.

Comments? Yes, we want to hear your thoughts. Tell us what you think about derivatives: as "financial weapons of mass destruction;" as a "shadow banking system;" as a "black market;" as the next big bubble dangerously exposing us to that unpredictable "bad 2%."