BUFFETT: This is the 'time bomb' in the markets

Nuclear bombPublic domainAn atomic bomb test.

Derivatives have Warren Buffett worried.

At Berkshire Hathaway’s annual meeting Saturday, Buffet and his partner Charlie Munger fielded a question on the use of derivatives by US banks.

“It’s still a potential time bomb if you were to get a discontinuity,” said Buffett.

Derivatives are financial tools that base their performance on a underlying asset. These can include things such as mortgage backed securities that track a bundle of home loans and helped cause the 2008 financial crisis.

Buffett said the level of derivative exposure at large banks is a “great danger” if there were to be a stoppage in markets, citing the example of the market closing during World War I and immediately after the September 11 terrorist attacks.

In this case, Buffett said that if such a discontinuity occurs, you lose the ability to properly track the underlying asset and can end up with a totally wrong price.

“Derivatives are still dangerous in large quantities,” said Buffett. “We would not do them on a collateralized basis because if there’s a large quantity, we don’t know where they’re going to end up [when marked to market].”

Buffett mentioned that he knew of a huge mispriced derivative that did not impact Berkshire’s investments, but did not elaborate.

His partner, Charlie Munger, echoed the sentiment but added that Berkshire made about $20 billion from different derivatives that the company has exposure to.

“We would have been happy if those sorts of derivatives were illegal,” said Munger adding that the country would be “better off” if they were.

Buffett also added that he was not worried about the exposure of Berkshire’s bank investments, such as Wells Fargo and Bank of America, to these derivatives.

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