Five years ago, investing icon Warren Buffett wrote in his letter to shareholders that derivatives are "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Yet Buffett has now revealed that Berkshire Hathaway finished 2007 with a $40 billion exposure to derivative contracts.
Berkshire had 94 derivative contracts at year-end, up more than 50 percent from 62 a year earlier. The company has earned $7.7 billion in premiums on the 94 contracts.
What gives? According to Buffett, recently named the world’s richest person by Forbes, there are two strategies at work:
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The first is a play in junk bonds. Berkshire has written 54 derivatives contracts, from which it earned $3.2 billion of premiums, requiring Berkshire to pay counterparties if specific bonds in several high-yield indexes default.
These credit default swaps run from now until 2013 and could expose the firm to losses of as high as $4.7 billion.
But Buffett says that’s a worst-case scenario that is "extremely unlikely to occur" and notes that, as of Dec. 31, Berkshire had paid out just $472 million on those contracts.
Still, he acknowledges that number is certain to rise.
Second is stock indexes. Berkshire wrote 40 put options, earning $4.5 billion of premiums, on the S&P 500 and on three foreign stock indexes.
Berkshire will have to pay on these contracts only if, when the options expire between 2019 and 2027, the indexes stand below their level when the contracts were written. Berkshire’s liability for these options totaled $4.6 billion as of Dec. 31.
However, Buffett argues that Berkshire’s derivatives are much less risky than those that have caused crises for major financial institutions like Citigroup and Merrill Lynch, a point outside experts concede.
First, "we have no counterparty risk,” Buffett wrote to his shareholders, because Berkshire sold the derivatives rather than buying them. "In all cases, we hold the money,” Buffett points out.
Chad Brand, president of Peridot Capital Management in St. Louis, scoffs at the idea that Buffett is a begin hypocrite on the subject of derivatives.
"Just because certain derivatives are extremely risky and may pose a serious threat to our financial system, that does not mean every single derivative contract is bad,” Brand writes on the Seeking Alpha web site.
"There are many derivatives that do not use tons of leverage and pose little threat, and those are the ones Buffett is using.”
Glenn Tongue, an investor with T2 Partners in New York, contrasted Buffett’s positions with the derivative risk taken on by troubled bond insurers MBIA and Ambac Financial Group.
"Berkshire has derivative contracts where it has been paid, and there is no counterparty risk,” Tongue tells Reuters.
"In the case of MBIA and Ambac, there is both counterparty risk with their reinsurance contracts and exposure to structured products. Berkshire doesn’t have that.”
Buffett told shareholders they should be prepared for gains and losses that could "easily” surpass $1 billion per quarter. Berkshire lost $89 million from derivative contracts in 2007.
Remember, though, that Buffett is utterly unconcerned about such short time frames. As he has said, his favorite holding period is forever.
"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,” Buffett wrote to shareholders.
"That is our philosophy in derivatives as well.”
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