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How Derivatives Help “To Evade Taxes, Circumvent Accounting Rules and Deceive Clients”

“While Warren Buffett has called derivatives “weapons of mass destruction,” they should be called “weapons of mass deception” since they are often used to evade taxes, circumvent accounting rules and deceive clients, New York Times columnist Floyd Norris writes.

Even national governments may have used the weapons of mass deception.

European newspapers recently revealed that Italy had used derivatives in the 1990s to make its budget deficit seem smaller in order to enter the eurozone, the Financial Times reported. 

Those derivatives could now mean a loss of 8 billion euros ($10.4 billion).

The European Union may have known about the financial smoke and mirrors but chose to overlook it, Norris noted, adding that joining the euro was more a political than an economic event at the time.

Companies — or nations it now seems — can use derivative contracts called futures contracts in which banks make large upfront payments in return for larger payments in the future.

Sounds like a loan, right? Except the company — or country — does not report the contract on its balance sheet or can report it in a misleading way in order to make its finances seem stronger. Enron was probably the most famous user of futures contracts, specifically prepaid forward contracts.

In credit default swaps, another type of derivatives, speculators pay a fee in return for a payoff when a company or country defaults.

That sounds like insurance, but if it were regulated as such, the issuing company would have to follow insurance regulations and hold reserves to pay claims.

AIG, probably the most famous user of credit default swaps, needed a government bailout when it couldn’t pay its losing bets on its swaps.

Current accounting rules do an inadequate job of requiring companies to report their derivative contracts, Norris argued.

Companies can net their derivatives positions, that is, offset a position’s gain against another position’s loss even if the two positions have little in common, he explained.

Most other countries require banks to ….”

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