By Jonathan Stempel
NEW YORK (Reuters) - Saying "derivatives are dangerous," Warren Buffett defended his use of them after they played the main role in driving Berkshire Hathaway Inc (BRKa.N)(BRKb.N) annual profit to a six-year low.
Buffett devoted one-fifth of his 21-page annual letter to Berkshire shareholders to explaining how he uses derivatives to make long-term bets on stock markets, corporate credit and other factors.
"It's part of a portfolio of risk assumption that people appreciate in capital markets, and helps cement relationships that lead to more business for Berkshire down the road," said Bill Bergman, senior equity analyst for Morningstar Inc in Chicago and a former Federal Reserve economist.
As regulators had requested, Buffett provided far more detail on the 251 derivatives contracts that Berkshire has, which the company said in theory could require $67.29 billion (47.36 billion pounds) of payouts in the event every bet went 100 percent wrong.
He also said investors should distinguish Berkshire's derivatives from others that dramatically increased financial leverage, made banks "almost impossible for investors to understand," and threatened the collapse of financial services companies such as investment bank Bear Stearns Cos and mortgage financiers Fannie Mae (FNM.P) and Freddie Mac (FRE.P).
"I believe each contract we own was mispriced at inception, sometimes dramatically so," he said. "I both initiated these positions and monitor them, a set of responsibilities consistent with my belief that the CEO of any large financial organization must be the chief risk officer as well. "If we lose money on our derivatives, it will be my fault."
Berkshire had $4.65 billion of net investment and derivative losses in 2008. Overall profit for the Omaha, Nebraska-based company fell 62 percent to $4.99 billion.
But Buffett believes Berkshire's derivatives differs from others that constitute "financial weapons of mass destruction," in part because of the billions of dollars of premiums that he collects upfront from counterparties.
FOUR TYPES
In its annual report, Berkshire said it has four major derivative categories.
The best known are equity index "put" options tied to where four stock indexes trade between September 2019 and January 2028. Berkshire revealed that these indexes are the Standard & Poor's 500, Britain's FTSE 100, Europe's Euro Stoxx 50 and Japan's Nikkei 225.
Because stocks have tumbled, Berkshire said it has a $10.02 billion paper liability on these contracts, and in theory could owe $37.13 billion if the indexes all went to zero. Buffett said these contracts "generally" may not be terminated early; such an event could result in losses for Berkshire.
A second category is contracts tied to credit losses in higher-risk "junk" bonds between September 2009 and December 2013. Berkshire said it has a $3.03 billion paper liability on the contracts, and could eventually owe up to $7.89 billion. Analysts said these may pose more of a nearer-term risk for Berkshire because of the shorter time frame.
The third category is credit default swaps, a kind of contract that has prompted government bailouts for the insurer American International Group (AIG.N). Berkshire said it began writing the contracts in 2008, and by year end had a $105 million liability on $3.9 billion of contracts covering 42 companies. Buffett said the business will not likely grow because he will not post collateral that most buyers demand.
Finally, there are tax-exempt bond insurance contracts structured as derivatives, on which there was a $958 million liability and $18.36 billion of potential losses. Buffett, however, said bonds insured by these derivatives are largely general obligation bonds, secured by states' taxing and borrowing power, and that "we feel good" about them.
"It could be important to monitor, to the extent economic weakness affects municipal finance and has implications for bond insurers to pay off investors," Bergman said.
BUFFETT SAYS 'DOWNS' PROVIDE OPPORTUNITY
Thomas Russo, a partner at Gardner Russo & Gardner in Lancaster, Pennsylvania, whose largest holding is Berkshire, said investors should downplay the volatility -- so far mostly downward -- that derivatives have caused in Berkshire results.
"Market pundits lament the counterparty risk, but it is misapplied because Buffett receives cash upfront," he said. "Warren did say that 'generally' the equity contracts are not callable, so there is a little wiggle room."
On the other hand, Berkshire carries triple-A credit ratings and has $25.54 billion of available cash. That suggests a strong ability to eventually pay off on any contracts. And if stocks rise over the next decade, losses on the equity put options could decline.
"Our derivative contracts, subject as they are to mark-to-market accounting, will produce wild swings in the earnings we report," Buffett wrote. "The ups and downs neither cheer nor bother (Vice Chairman Charlie Munger) and me. Indeed, the 'downs' can be helpful in that they give us an opportunity to expand a position on favourable terms."
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