Berkshire's 31% Decline Spurred by Derivatives Buffett Derided

By Richard Teitelbaum
Bloomberg News
April 28, 2009

April 28 (Bloomberg) -- Berkshire Hathaway Inc. shareholders have a chance this year to do something that's rare among the Sage of Omaha's followers: count their losses.

Despite Berkshire's reputation as a bear market bulwark, its stock has been walloped. The Class A shares are down 31 percent since September, to $90,000 as of yesterday, exceeding the 26 percent drop in the Standard & Poor's 500 Index.

One reason: Chief Executive Officer Warren Buffett's increasing use of derivatives -- contracts whose value is based on the performance of stocks or bonds or the outcome of a specific event. That Buffett once called derivatives "time bombs" doesn't calm investors.

Berkshire held contracts with a combined notional value of $67.3 billion at year-end. While this figure is used mostly for reporting purposes and isn't indicative of potential losses, it dwarfs the company's $25.5 billion in cash.

Buffett himself has warned of an increasing possibility he might have a loss from one type of contract on Berkshire's books. Fitch Ratings and Moody's Investors Service have lowered their credit ratings on Berkshire, partly because of the derivatives.

"People have become uncomfortable with financial investments that they don't understand, especially anything related to derivatives," says Charles Bobrinskoy, a manager at Ariel Investments LLC in Chicago.

Equity Index Puts

Berkshire's derivatives fall into four categories. Because they carry the greatest notional value, at $37.1 billion, most attention is on put options that Buffett sold on stock indexes in the U.S., U.K., euro zone and Japan that expire from September 2019 to January 2028. Berkshire has to pay at expiration if any of the indexes are lower than they were when the puts were written.

While analysis of these bets shows big losses are unlikely, Buffett, 78, hasn't provided sufficient information on the derivatives to keep some investors from hitting the sell button. Bobrinskoy says he hasn't been scared away: Of the $250 million he co-manages at Ariel, 5.6 percent was invested in Berkshire as of March 31.

To lose the full $37.1 billion on the equity puts, the indexes would have to fall to zero -- an unlikely event. Berkshire received $4.9 billion in premiums, which together with what the company earns on it, may offset any eventual payments.

Market Scenarios

Citigroup Inc. analyst Joshua Shanker in a March 16 report examined several scenarios to gauge the likelihood of Buffett's losing money on the puts. Using the S&P 500 as a proxy for all the indexes and assuming a 5 percent annualized return on the premium, the market would have to suffer a cumulative decline of at least 32 percent across the 15- to 20-year life of the contracts for the seller to lose money. In the U.S. market back to 1800, the only way to do that would be to start the bet just prior to the 1929 crash.

Some economists compare today with the Great Depression, and some of the puts may have been written near the U.S. market's all-time high in late 2007, according to information Buffett has disclosed. The S&P 500 in March was down 57 percent from its peak.

With that in mind, Shanker looked at scenarios that begin with a 50 percent drop in the S&P 500. From that nadir, if the index rose 6 percent annualized over 14 years, Buffett still would not owe any money when the puts expire -- even without consideration of the $4.9 billion in premiums.

Potential Losses

Shanker also sketched out grimmer scenarios. Starting with the 50 percent decline, if the S&P 500 rises at the stock market's post-1800 average annual rate of 2.8 percent, Berkshire could be out $5.4 billion at the end of the bet. That assumes an initial one-third loss on the premiums followed by 2.5 percent annualized returns.

David Winters says losses from these derivatives are unlikely. His Wintergreen Fund had 6.6 percent of its assets in Berkshire, as of year end. "We're living in a world where there's so much negativity, investors are extrapolating something that's just remotely possible into something that's probable," he says.

Berkshire hasn't disclosed sufficient information to fully analyze its other derivatives, Shanker says. One category is simply municipal bond insurance structured as derivatives; the risks here are similar to those for his municipal bond insurer. Another type consists of credit-default swaps through which Berkshire guarantees payment of individual corporate bonds. Those bets were relatively small, totaling $3.9 billion in notional value at the end of last year.

Worrisome Bets

The final category is the most worrisome, Shanker says. Berkshire has sold contracts that require it to pay when credit losses occur at companies that are included in certain unnamed high-yield-bond indexes. The notional value is $7.9 billion.

Berkshire took in $3.4 billion in premiums on these contracts and has paid losses of $542 million. The company has also recognized a noncash, $3 billion mark-to-market loss. With these contracts, payments are made when a credit event occurs. They expire from September of this year to December 2013.

Losses on these contracts are accelerating as bankruptcies grow, Buffett said in his shareholder letter in February. "Now with the recession deepening at a rapid rate, the possibility of an eventual loss has increased," he wrote.

Buffett didn't respond to an e-mailed request for comment. He is scheduled to address shareholders at Berkshire's annual meeting on May 2, and quarterly results are expected from the company on May 1.

'Handpicked' Risks

Mark Curnin, co-founder of White River Capital LP, an investment partnership that specializes in financial stocks, says Buffett's derivatives are simply smart ways to do what he's always done: underwrite insurance and buy attractive securities.

"Buffett has handpicked a select group of risks that he understands and thinks are attractively priced," he says.

The derivative risks are similar to the other hazards that might worry any investor in Berkshire. There are volatile profits from its insurance subsidiaries, for example, and units that depend on the housing industry, such as Acme Building Brands and Clayton Homes Inc. Then there's Buffett's portfolio of equity investments: While easy to understand, 7 of the 14 largest holdings listed at year-end were carried at a loss.

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