Mark-to-market accounting of instruments has made earnings more volatile
OMAHA, Nebraska (MarketWatch) -- Berkshire Hathaway Chairman Warren Buffett and Vice Chairman Charlie Munger on Sunday defended the company's foray into derivatives.
In his 2003 letter to shareholders, Buffett called derivatives "financial weapons of mass destruction." However, Berkshire (BRKA:BRKB) has built up more than $40 billion in these contracts in recent years.
"Anything we've done isn't endorsing that the world get drunk on derivatives," Buffett told a press conference Sunday. "I don't think we've done much to encourage the development of derivatives."
Munger said Berkshire doesn't have an obligation "to avoid types of business because we believe the area needs to be regulated more."
During Saturday's annual meeting, Buffett warned that one type of credit derivative written by Berkshire has deteriorated in recent months because of an increase in corporate bankruptcies.
Those derivatives have "turned worse since I wrote the annual report," Buffett said.
The potential and expected losses from these credit derivatives were reflected in Berkshire's first-quarter results, he added.
Buffett also described one consequence of Berkshire's foray into derivatives that he didn't foresee.
When the company's derivatives positions went against it during the turmoil of the fourth quarter, Berkshire didn't have to post collateral on most of its agreements. However, some counterparties hedged themselves by buying credit default swaps against Berkshire.
As Berkshire's positions deteriorated more, some counterparties bought more CDS protection, pushing CDS prices on Berkshire up sharply. Buffett said that was a problem he didn't anticipate.
Berkshire lost its AAA debt ratings in April and some Berkshire shareholders have said the downgrades were partly caused by concerns and misunderstanding about the company's derivatives positions.
Berkshire has a $37.1 billion portfolio of put option contracts on the Standard & Poor's 500 Index ($SPX:$SPX, , ) , the FTSE 100 (UK:UKX: news , chart , profile ) in the U.K., Japan's Nikkei 225 (JP:1804610: news , chart , profile ) and the Euro Stoxx 500 in Europe. The derivatives require Berkshire to pay its counterparties if these equity indexes fall below where they were when the contracts were signed.
Most of these agreements were set up more than a year ago, when stock markets were much higher, so Berkshire is in the red now.
"I'm pretty comfortable on the valuation of those contracts, but the market is more concerned," Morningstar equity analyst Bill Bergman said before this year's annual meeting. "When there's been a 40% decline in the S&P, it's right that people who have written puts on the S&P are going to be looked at more closely."
However, the contracts don't mature for 15 to 20 years, and Berkshire doesn't have to post collateral to its counterparties. The company also got premiums of $4.9 billion for taking on these risks, and that's money Buffett has been investing.
"Getting the upfront premium gave him more money to invest," said Janet Tavakoli, president of Tavakoli Structured Finance and a long-time holder of Berkshire class A shares. "But when there's a lot of volatility and the index goes down, he has to keep more cash to support the positions and maintain creditworthiness."
Berkshire also has more than $4 billion of credit derivatives, including credit default swaps, which require the company to pay counterparties if certain companies go bankrupt.
Most of these contracts don't require Berkshire to post collateral if the market turns against it before the agreements mature. Indeed, during the chaotic fourth quarter, Berkshire had to post less than 1% of its securities portfolio to counterparties, Buffett noted in his latest shareholder letter.
"Analysts who follow the company aren't skilled enough to know that, while these contracts impact the income statement, they have no cash or collateral impact on the company and won't have any real economic impact on Berkshire for many years," said Thomas Russo, a partner at Lancaster, Pa.-based Gardner Russo & Gardner, which owns Berkshire shares.
Earnings more volatile
One type of credit derivative Berkshire wrote requires the company to pay when losses occur at companies that are included in several high-yield, or junk, indexes. The standard contract runs for five years and is tied to 100 companies, although the average life of Berkshire's contracts are now less than three years.
Berkshire made $97 million in payments in these credit derivatives in 2008. But Buffett warned in late February that losses have accelerated sharply amid a rash of bankruptcies.
"With the recession deepening at a rapid rate, the possibility of an eventual loss as increased," Buffett warned in his latest letter to shareholders.
On Saturday, Buffett said these credit derivative positions had deteriorated more since he wrote the letter in late February.
The derivatives have made Berkshire's quarterly earnings reports more volatile, as the company uses mark-to-market accounting to reflect short-term changes in the value of the contracts.
Buffett said in February that he's not worried by derivative-fueled "wild swings" in reported earnings and expressed hope that shareholders don't worry either.Alistair Barr is a reporter for MarketWatch in San Francisco.
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