In his ''chairman's letter'' to shareholders of Berkshire Hathaway in 2002, American investor Warren Buffett delivered an analysis of derivatives and the trading activities that go with them. ''We view them as time bombs, both for the parties that deal in them and the economic system.'' In his view the companies and individuals that traded derivatives (instruments that call for money to change hands at some future date with the amount to be determined by one or more reference items, such as interest rates, shares prices or currency values) had enormous incentives to cheat in how they accounted for them. Derivatives were complex and not easily understood by investors and analysts; their risk was not easily laid off with other parties; and they had the potential to exacerbate trouble that a company had run into for completely unrelated reasons.

Buffett wrote, ''The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.''

Tuesday's decision by the United States Federal Reserve to, in effect, take over insurance giant American International Group at a cost to taxpayers of $US85 billion ($A106 billion) shows just how prescient Buffett's forecast was.

AIG is a large multinational insurance group with a reputation for solid underwriting and risk management. Some years ago, it decided to diversify into derivatives and mortgage-backed securities, a business its senior managers no doubt believed would yield fat profits. They did initially, but in the process AIG exposed itself to derivatives contracts nominally worth $US441 billion, and which have led to losses of $18 billion in just the last three quarters.

Had it not been for the US housing market collapse of last year and the ensuing credit squeeze, the company just might have traded its way out of difficulties, or at least been broken up and sold off in orderly fashion (its assets at the end of June being worth $US1.05 trillion). But, after its credit rating was cut on Monday, AIG's shares slumped dramatically, leading to fears of a collapse that many felt could have caused a global financial catastrophe.

That threat to the global economy is why the Fed acted, in effect nationalising AIG when just days earlier it had refused to countenance a rescue of investment bank Lehman Brothers.

In March the Fed helped J.P. Morgan Chase buy Bear Stearns (by providing a credit line of $US29 billion), and earlier this month the US Treasury took control of the troubled US mortgage giants Fannie Mae and Freddie Mac rescues that led some analysts to question why the financial markets and the managers of the companies who had profited handsomely from the trade in derivatives and other complex financial instruments should be rescued by Uncle Sam rather than facing the consequences of their imprudence and greed.

The willingness of authorities to let Lehman Brothers go to the wall was, for many analysts, a welcome statement of free-market discipline, but there was little likelihood the US Government could allow AIG to fall. It was too large and the risk of contagion was too great to allow it to undergo ''disorderly failure''.

The size of the rescue is unprecedented: AIG's $A106billion loan has been secured against its best assets, in return for a Government stake of 79.9 per cent. As expected, there are strings attached: the rate of interest is punitive, and the Government has given itself the right of veto over major decisions, and demanded the company's existing management be replaced.

Are there other unexploded time bombs? Undoubtedly and these will come to light when other US financial institutions that have traded extensively in derivatives, such as hedge funds, report.

The linkage with the current credit squeeze virtually guarantees there will be more failures. And if, in the judgment of the US Treasury, these failures are likely to threaten the integrity of the US economy, they will have little option but to intervene. Even before that happens, questions are being asked about enormous fiscal costs imposed on the US economy as a result of the expansion in debt necessary to bail out AIG, Fannie Mae and Freddy Mac.

A slowing of growth because of higher taxes and lower spending seems inevitable. Should this be accompanied by a slide in the value of the dollar, further volatility in financial markets seems inevitable.Some analysts are predicting that the cost of cleaning up after the credit crunch could reach $1 trillion, even $2 trillion.

The world should be relieved that the US Government has acted decisively to contain the damage, though it may wonder why more American regulators did not pay attention to Warren Buffett's warnings.