In Letter, Warren Buffett Concedes a Tough Year (Excerpt)
New York Times - March 1, 2009
by David Segal

Still, Mr. Buffett’s report was greeted with sighs of relief among some shareholders. “I’m delighted,” said Janet Tavakoli, a derivatives expert and author of Dear Mr. Buffett, about the credit crisis of 2008. “Of course it was a tough year — the toughest year of his life. But I was concerned about the impact in operating earnings and I was prepared for much worse.”

End of Excerpt

JT Note: There is an advantage to avoiding the big mistakes (such as investing in and then borrowing against assets that permanently destroy value).

Comments on Berkshire Hathaway's Derivatives: One can ride out the rough times and be well-positioned for the eventual economic improvement. In the wake of the 2008 Shareholder Letter (see link below), there is a flurry of news articles on the derivatives held by Berkshire Hathaway, but most leave out important information.

On pages 18-20 of the letter, Warren Buffett discusses the derivatives contracts including his view of weakness of the standard-practice Black Scholes model for pricing long-dated stock options. It overstates the liability—the unrealized loss (meaning no money is paid out today, and perhaps not ever) for long dated stock index put options.

In general, it is important to note the following about the derivatives positions:

Only a small percentage of Berkshire Hathaway’s contracts require it to post collateral to counterparties when the value of the contract moves against Berkshire Hathaway. Berkshire Hathaway posted less than 1% of its securities portfolio as collateral. (You may recall AIG was required to post collateral on many of its derivatives contracts and was unable to meet its obligation without intervention. Even if Berkshire Hathaway had agreed to similar terms—and it did not—it has the wherewithal to meet its obligations).

Most of the liabilities due to these contacts are unrealized losses, meaning there is no current payment due.

For example, Berkshire Hathaway currently has a $10 billion liability for various stock index puts as priced using the standard-practice Black Scholes model. Notice that the notional value of the options is $37.1 billion (at current exchange rates), but that amount would only be due if all the indexes involved fell to zero and it would only be due on the future expiration dates ranging from 2019 to 2028. There is no payment currently due.

But Berkshire Hathaway has already received $4.9 billion in premiums, and it has invested this money. This offsets the $10 billion unrealized (not paid out) loss in the value that the model calculated. The net liability is $5.1 billion as shown on P. 18, but to reiterate, it is an unrealized liability, and would only be due, if ever, at the future expiration dates of the contracts (ranging from 2019 to 2028).

Will Berkshire Hathaway ever have to make a payment? Do you think that the stock market will recover to the levels at which Berkshire Hathaway initially did these trades? If so, there would be zero payment when these contracts expire in 2019 to 2028, and Berkshire Hathaway will pocket the future value of the $4.9 billion it received in premiums. Do you think the stock market will recover only part way, say to the level where Berkshire Hathaway is paying out less than the future value of the $4.9 billion it invested?

Even if your outlook is so pessimistic that you think Berkshire Hathaway would have to make that future payment, its current financial situation suggests it could pay out (and them some) under any scenario, which is what we used to mean by “AAA.”

[For a discussion of credit derivatives see P. 19 of the shareholder letter and see also chapter 2 of Dear Mr. Buffett.]

Click here to read Warren Buffett’s 2008 Letter to Berkshire Hathaway Shareholders

END OF EXCERPT

Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct professor of derivatives at the University of Chicago's Graduate School of Business. She is the author of: Credit Derivatives & Synthetic Structures (John Wiley & Sons, 1998, 2001), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, 2008), and
Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street (John Wiley & Sons January 2009)

Clients of Tavakoli Structured Finance have the benefit of proprietary consultation, which is not available in any other paid or public forum. Clients also commission proprietary research and analysis.

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