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Is This the End of Berkshire Hathaway?

Morgan Housel
March 2, 2009

Nothing lasts forever. There's no such thing as a free lunch. If it sounds too good to be true, it is. If it can't keep going, it won't. Caveat emptor.

Call it what you will. Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) did something it hasn't done since Warren Buffett took the helm in the mid-60s: It had a terrible year.

Had to happen eventually
OK, maybe not terrible, but its worst ever by far. Per-share book value fell 9.6% in 2008, marking only the second time since 1965 it recorded negative results.

Berkshire's share performance, unfortunately, has been markedly worse. Shares are off 45% in the past year, falling back to 1998 levels.

Such is life. Most stocks are on a similar trajectory these days. Factor in investments in battered financials like Wells Fargo (NYSE: WFC  ) , American Express (NYSE: AXP  ) , and Bank of America (NYSE: BAC  ) , not to mention its dozens of operating subsidiaries waist-deep in industries like construction and retail, and a 45% plunge probably seems justified.

That, however, is hardly the main driver behind the recent nosedive. The growing fear is not necessarily over Berkshire's core holdings; above all, the worry is over a set of equity derivatives that, thought goes, could ultimately implode Buffett's track record of domination.

No one's perfect
Over the past few years, Berkshire sold a boatload of derivatives that effectively bet on the long-term strength of global stock market indices. By selling equity put options, it agreed to pay huge sums of money if the indices fell below levels they were initially struck at when the contracts expire -- which fall at various times between 2019 and 2028.

Since most of the options were sold in the glory days of yesteryear-- when indices were as much as twice as high as they are today -- Berkshire's current mark-to-market loss sits at $10 billion and grows by the day -- as global markets disintegrate.

Here's where the doomsayers come in: If indices fall to zero on and between 2019 and 2028, Berkshire could be on the hook for as much as $37.1 billion. That, even by Berkshire standards, would be a catastrophic loss.

It's all a bunch of ballyhoo
Nothing seems impossible after these last 12 months. Talk about stock markets becoming worthless, and rational people take you seriously. Still, let's be real: If major stock indices go to zero, Berkshire's liabilities won't be on anyone's mind. Guns, ammunition, canned food, and bomb shelters will be.

More importantly, the uproar ignores the most important part of the derivative contracts: that Berkshire received $4.9 billion up front, and won't be liable for a penny until they expire between 2019 and 2028. I know: $4.9 billion is peanuts compared to a potential $37.1 billion liability, but it's still a lot of money, and 10-20 years is a long time.

Long enough, in fact, that even if the derivatives do ultimately end up in the red, the future value of the $4.9 billion would likely offset even a massive loss. Using a 15-year timeframe (roughly the average time from now until 2019-2028), here's the pre-tax compounded value of $4.9 billion under different returns:

Annual Return