Buffett's Derivative Play

In its recent first quarter statement, Berkshire Hathaway released that it has bought derivatives on various stock indexes that were set to expire between 2019 and 2028. The indexes of interest for Berkshire include the FTSE, Euro Stoxx 50, Nikkei, and S&P 500. The derivative plays included multi-billion dollar positions that involved selling puts on the indexes. The report has Berkshire with $4.5 billion in premiums and $4.6 billion in liabilities at the end of 2007.

Apparently, Berkshire is not done and is continuing to increase its position in Q1, where premiums increased by $383 million by selling additional puts. This increases its derivative liabilities to $6.2 billion. In Q1 the positions went against Berkshire, causing it to record a loss of $1.2 billion. Given the long expiration dates, the losses appear to be mainly mark-to-market accounting losses, and not positions that have been closed. Each of the indexes that puts have been written against have been down collectively for the year.

Of interests is that since $4.5 billion was generated in premiums in 2007, the notional value of the assets (indexes) themselves could be estimated to be in the range of $70-$100 billion. While Berkshire's insurance businesses has surly used derivatives to hedge risk, this direct move into derivatives is both surprising and understandable at the same time.

On the one hand, Buffett has repeatedly talked about derivatives being "financial weapons of mass destruction," and something that has contributed to the current problems we are experiencing in the markets. Granted, there is a big difference between writing naked puts and exposure to a CDO-squared, where counter-party risk is not only huge, but often at times unknown. Nonetheless, it is an interesting move and turn of events.

On the other hand, Berkshire's large insurance businesses have been providing a large float for Buffett to redeploy. The writing of naked puts will now provide extra income that can be put to work, albeit at a different level and degree of risk. Furthermore, the move signals that Buffett feels that any market correction is over, and that the indexes are going up. If you believe this, as Buffett apparently does, then selling puts would seem less risky, and would also give you the cash you need to begin buying relatively cheap assets that you expect will be moving up from recent lows. Buffett has said as much, stating recently that he believes the worst of the credit crisis is over for Wall Street and the markets, even though individuals will still feel pressure. With the recent moves, Buffett is certainly putting his money where is mouth is. Finally, in addition to market direction bias, this move may also be giving us clues about the insurance business, and the level of float that Berkshire needs and expects to receive in the future. Time will only tell how all this plays out for Berkshire and its shareholders. I am sure some are surprised, excited, and a little anxious.

Tickers: BRK.A, BRK.B