The Alarmist of Omaha.(Warren Buffett)

Do you know what feline pride means to a money manager? (Flexible equity-linked exchangeable security.) A Synthetic CDO? If the acronyms sound exotic, the truth is that these are garden-variety derivatives, a fast-growing form of investment now used by nearly every major bank and corporation in the world. If you've got a retirement fund, your future is probably tied up one way or another in derivatives, which is why this story may alarm you. For derivatives have been making news lately both for dramatic growth--and for widening concern that they are the tangled tripwire for the next major global financial meltdown. As Berkshire Hathaway chair Warren Buffett put it recently, derivatives threaten to become "financial weapons of mass destruction."

This is not how it was supposed to work out. Derivatives are as old as civilization: Aristotle referred to an option on the use of olive-oil presses in his "Politics" some 2,500 years ago. The idea behind derivatives is to reduce risk by offering investors a chance to hedge against future movements of anything from interest rates, to commodity prices, even weather. Say you've got a lot of money in oranges-- derivatives let you hedge against the risk of a cold snap. The problem: the derivatives market is now so big and so complex, the world is wagering stunning sums on bets it can't possibly understand. The market for OTC (over the counter) derivatives rose from $2.9 trillion in 1990 to $128 trillion in 2002. And while companies in the 1980s traded "plain vanilla" interest-rate swaps, since then Enron, WorldCom, Global Crossing and others have unraveled in part due to convoluted derivatives deals the forensic accountants are still trying to figure out.

Buffett is not the first to raise the alarm. As former derivatives trader and law professor Frank Partnoy outlines in a new book, "Infectious Greed: How Deceit and Risk Corrupted the Financial Markets," others tried over the past decade. In the mid-1990s, a rise in the use of OTC derivatives helped contribute to disasters like the bankruptcy of California's Orange County. According to Partnoy, calls for new market legislation were beaten back by powerful industry lobbyists. Even after the infamous hedge fund Long Term Capital Management nearly brought down world markets in 1998 thanks to complex derivatives trades concocted by Nobel Prize winners, regulators still failed to act, in part because the deals had gotten too complicated. Government accountants simply couldn't keep up.

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