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Not even Warren Buffett’s empire is immune from derivative risks and disclosure struggles. Indeed, It appears that Berkshire Hathaway underestimated the risks of falling stock prices to the derivative bets that it has. Stock Market Funding reports on Berkshire’s admission to the Securities and Exchange Commission:

Berkshire revealed its error in a June 26 letter to the SEC, one of several pieces of correspondence with the regulator about the company’s annual report, and made public on Thursday. It also agreed to SEC demands for more explanation on $1.8 billion of writedowns on stock investments, and $2.7 billion of auction-rate and other municipal debt holdings. On June 29, the SEC said it completed its review without further comment.

This is actually rather interesting, since Warren Buffett once referred to derivatives as weapons of financial mass destruction. And he did this at the beginning of the decade when derivatives were coming into popularity. But apparently they weren’t seen as quite so risky as to avoid them altogether. And it also illustrates another important point: Berkshire probably has enough non-risky holding to get through this mess. It’s all about asset allocation. Even with the losses, Berkshire is still probably in good shape.

Of course, this news also brings to light that there is no such thing as “full-proof”. Even the savviest investor and money manager can make mistakes and questionable decisions. In the end, a solid long-term investing strategy that you understand is one of the best defenses against devastating losses.

Disclaimer: I am not an investment professional. Nothing in this piece or on this Web site should be construed as investment advice. Before making investment decisions, do your own research and/or consult with an investment professional. All investment comes with the risk of loss. You are responsible for your own investment decisions and any loss that may result from your decisions.

One of the biggest problems with mortgage backed securities prior to the financial market meltdown was the fact that many of the “pools” of mortgage backed securities were murky. A certain percentage of high risk mortgages were mixed in with good quality home mortgage loans, but the ratings did not reflect these risks. Many investors thought they were investing only in high grade home mortgage loans, when, in fact, they also held a certain amount of risk that they were not aware of. Naturally, when the subprime mortgage crash began, and many of these mortgage backed securities turned out to be exposed to risk, there was a massive attempted exodus from these investments.

However, mortage backed securities are an important part of the mortgage industry. They represent a needed secondary market that helps provide continued capital for the housing industry. So efforts have been underway since the middle of last year to overhaul mortgage backed securities. Julie Messina reports in the Examiner on the thrust of new mortgage backed securities regulations:

Senior industry policy makers and ASF professional staff are developing transparency, disclosure, and due diligence standards for new Residential Mortgage Backed Securities (RMBS).  On July 15, 2009 the ASF issued the Final Release of the ASF RMBS Disclosure and Reporting Packages.   If you look at the loan level data fields that begin on page 37 of this document you will have a better appreciation for how the industry is holding industry participants accountable for the accuracy and integrity of the mortgages that make up a pool of loans. There is no room for error. Those looking for a loophole to profit financially at the expense of others will not be able to do so.

For now, disclosure is a major part of the new regulations. Indeed, many of the new investing rules are centered around disclosure. It is important for investors to be able to make informed decisions about their investments, so that they understand the risks involved.

The derivatives market has been widely derided as one of the reasons (but not the only) that we ended up with a global financial crisis and a recession. Indeed, these derivatives were complex financial instruments that many did not understand — or know how to value. Part of the problem of buying toxic assets right now is that no one really knows how much derivative-based assets are worth. In order to prevent the same sort of problem in the future, the Obama Administration is proposing tighter derivative regulation and requiring some measure of transparency. StockMarketFunding reports on the broad aims of the new regulatory moves:

As the AIG situation has made clear, massive risks in derivatives markets have gone undetected by both regulators and market participants. But even if those risks had been better known, regulators lacked the proper authorities to mount an effective policy response.

Today, to address these concerns, the Obama Administration proposes a comprehensive regulatory framework for all Over-The-Counter derivatives.

Moving forward, the Administration will work with Congress to implement this framework and bring greater transparency and needed regulation to these markets. The Administration will also continue working with foreign authorities to promote the implementation of similar measures around the world to ensure our objectives are not undermined by weaker standards abroad.

The real question, however, is whether such regulation can even be effective. Since derivatives are complex and very few people understand them, there is a question as to whether or not the regulators will even be qualified to know whether transparency is being practiced. Additionally, depending on whether or not an anti-regulatory mood sweeps the political and financial leaders in the future (as it did in the early 2000s), the regulations made today could be cast aside in a few years — possibly starting this cycle over again.

Personally, these types of investments, and all the excitement surrounding their regulation, is one of the reasons I stick with a boring investment strategy that includes buy and hold investing and index funds.

Disclaimer: I am not an investment professional. Nothing in this piece or on this Web site should be construed as investment advice. Before making investment decisions, do your own research and/or consult with an investment professional. All investment comes with the risk of loss. You are responsible for your own investment decisions and any loss that may result from your decisions.