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Buffett Crosses Over To The Other Side


I often hear people quoting Warren Buffett saying “Derivatives are weapons of mass destruction”, and thus, that derivatives are ultra-horrible, a bad thing, a sin, and what not.

What Buffett says is not what Buffett always does. Berkshire Hathaway, the company he runs, had it’s net income falls64 percent because of derivatives.

Berkshire Hathaway Inc. said Friday its first-quarter profit fell 64 percent because it recorded an unrealized $1.6 billion pretax loss on its derivative contracts, and its insurance businesses generated lower profits.

Berkshire reported net income of $940 million, or $607 per share, in the quarter ended March 31. That’s down significantly from the net income of $2.6 billion Berkshire generated a year ago.

Berkshire’s chairman and CEO Warren Buffett warned shareholders in his annual letter that the derivatives could make the company’s earnings volatile. But he predicted the derivatives will ultimately be profitable.

Including the derivative losses, Berkshire’s net investment losses in the quarter totaled $991 million. A year ago, the Omaha-based company recorded a $382 million investment gain.

Berkshire’s derivatives fit into two major categories. Berkshire will have to pay on some of the contracts if certain U.S. entities default on their credit. Most of the other derivatives will only be paid if the certain stock indices are lower in 15 or 20 years than they were when the contract was written.

Berkshire has received $2.9 billion in premiums on the credit-default derivatives and $4.9 billion on the stock index derivatives.

Berkshire said its operating earnings are a better measure of how the company is performing in any given period because those figures exclude derivatives and investment gains or losses. Berkshire reported $1.93 billion in operating earnings during the first quarter, which was down from $2.21 billion in operating earnings a year earlier.

Berkshire’s insurance group, which includes Geico, reinsurance giant General Re and several other firms, contributed $181 million to net income from underwriting new policies. A year ago, Berkshire’s insurance companies generated a $601 million underwriting profit.

Buffett has said he expects insurance profits to fall during 2008 because increased competition has driven premium prices down, and a catastrophic loss could further hurt insurance profits.

Emphasis mine.

Now I don’t think you should hold Buffett to his word. This is a business where being fickle is a good thing. When circumstances change, you change. Buffett probably meant his mass destruction statement when derivatives were being sold with no idea about risk. But today when risk is priced in, derivatives are much more attractive for a value investor.

Berkshire’s business itself is partly insurance. Insurance, I believe, is like a derivative, and that is in effect what Buffett has done – insurance on certain credit not defaulting, and insurance on the index not falling over twenty years.

Not that it is a good idea because I have no idea what twenty years will do and would never write the insurance. You can only come out in two ways – looking like a hero, or totally bankrupt. There’s no “in-between”. And the number of events, or “black swans” that can happen are ridiculously high – high enough to bankrupt you.

Take the put option Buffett has written on stock indices. Assume a 50% fall from here. He has received about $4.9 billion in premiums. For example a Dow Jones Index put at 12,000, over 20 years, he might get around $1165 per unit, and since they’ve said around $4.6 billion total premium received, means around 4 million shares which translates to a strike value of $48 billion. Margin requirements for such options are typically $2.5 billion (at 5% margin). That means for an equivalent put option, the margin required is $2.5 billion, for an exposure of $48 billion. If the index falls 50% anytime in the next 20 years, there will be a mark to market loss of $24 billion (though the option cannot be exercised until 20 years later). This $24 billion will be required as a maintenance margin, cash that the company can’t technically use. Right now the company has around $36 billion, but if the stock markets hit lows, the cash may be required to purchase or bail out companies – the way Buffett has traditionally grown. Not having that avenue is horrendous – and this is just one index option written – there are other things that require margins (insurance, CDS etc.)

It may sound like a 50% loss is not quite forthcoming or in the horizon, but who can ever see these things? I would want to be on the buy side of that equation, using short term puts as a hedge instead. Far more predictable, and controllable and loss protected.

And that’s just the index puts. There are credit derivatives, which assume no credit defaults by the underlying companies. What if that doesn’t pan out?

Coming to the rest of the highlighted items. Note carefully – operating income has gone down. Insurance business has gone down in 2007, and is expected to be worse in 2008. Businesses like Amex, Wells Fargo et. al. are due for a subprime hit, and the residential problems will hit the furniture/carpeting businesses. Life isn’t going to be easy the next few years.

In a lot of ways, this is huge change in outlook for one of the world’s most admired investors. We must wait and see how well he reacts. One lesson though: Do not believe what Buffett says is what Buffett will always do. Because in this business, people change – and for good reason.


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