December 10th, 2008Warren Buffett And Derivatives
Warren Bufett’s derivative positions in his Berkshire Hathaway fund are being discussed more frequently lately. In 2003, billionaire Warren Buffett called financial derivatives “the ultimate financial weapon of mass destruction“. That claim has become all to clear in the midst of the 2008 financial crisis, claiming such formerly perceived indestructibles such as Bear Sterns, Lehman Brothers, Countrywide, Washington Mutual and others.
Financial derivatives are essentially side bets on the market and come in many forms. That can be as innocent as an option covered call contract sold against a position you already own. But they can also approach destructive levels, as in the case of AIG’s selling hundreds of billions of dollars in credit default swaps that it had no capacity to honor. AIG is now the recipient of a massive taxpayer subsidized bailout package.
Berkshire Hathaway does currently hold several billion dollars in derivative contracts. Here are a few excerpts from the latest Berkshire Hathaway annual report.
Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories.
First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.
We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in “Derivative Contract Liabilities” on our balance sheet. The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.
Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.
Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.
Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.
The 2008 annual report is not expected out for several more months, but Buffett is certain to announce even larger derivative bets when it does. He has reportedly sold larger chunks of naked puts in the major indexes over the last few months to take advantage of market lows and high volatility. According to this Bloomberg article, Berkshire currently has about $35.5 billion in naked put options with expirations starting in 2019. But unlike AIG, and as highlighted in the annual report above, Berkshire does have the cash to cover all derivative bets.
