The American Spectator

Looking back, what’s amazing about Buffett’s warnings on derivatives is not merely that he said they could be dangerous — many others did — but that the scenarios he spoke of were eerily similar to what we’re witnessing today.

AIG faltered because in addition to its regular insurance operations, the company owned a massive amount of credit default swaps, which insure large bondholders against the risk of default. As a result of rising defaults stemming from the housing crisis, AIG suffered tremendous losses, leading to a dwindling stock price and Monday’s downgrades by the major ratings agencies. Collapsing under the weight of huge collateral obligations, the company was forced into the arms of the Fed, which will take an 80 percent stake in what was once the world’s largest insurer.

p>Back in his 2002 annual letter to his shareholders (which was written in February of 2003), Buffett theorized: br> /p>

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

br> On Tuesday, as AIG fought for its life, shares of Buffett’s Berkshire Hathaway rose more than 4 percent.