Wednesday, April 28, 2010

Why you should take Warren Buffet's derivative assertions with a grain of salt

Originally posted in the Wall Street Journal by Matt Phillips:

Warren Buffett’s assertion that derivatives are “financial weapons of mass destruction” is probably the best known association between the Berkshire Hathaway chief and the financial instruments of the moment....

But... Buffett’s relationship with derivatives is more complicated than it first seems. Barclays Capital analysts wrote back in early April:

“Berkshire Hathaway attracted attention in 2008 and early 2009 due to its growing derivatives exposure. The company increased its exposure to fluctuating investment valuations by selling long-dated put options on equity indexes and high yield indexes as well as credit default protection for states/municipalities and individual corporations with a total notional value of $63 billion.”

In fact, in his most recent letter to shareholders, Buffett relayed that derivatives were a boon to the company in 2009. The Journal’s Scott Patterson reported back in March:

The company also benefitted from several derivatives contracts it entered into in recent years. The contracts are insurance policies against long-term declines in U.S. and foreign stocks and expire during the next two decades. Berkshire will have to pay money if the indexes are below where they were when it entered the contracts. Berkshire posted an after-tax gain in derivative contracts of $486 million in 2009, compared with a loss of $4.6 billion the previous year.

So exactly where does Buffett stand on derivatives? It’s simple, he stands — as most business people do — where he thinks he has to in order to get the most out of his portfolio.

Here’s how he put his thoughts — and the thoughts of his longtime partner Charlie Munger — in his most recent letter to shareholders:

We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998. The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme. At Berkshire nothing like that has occurred – nor will it.

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