Berkshire Derivatives Surprise?
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By rclosch
April 9, 2007

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First quarter

Part 2 Investment and Derivative Gains

Operating business income may not be the only surprise in Berkshire's first-quarter report. Last year, the big story, coming in, was the hard market in the Insurance business, but it turned out in the end, that the strongest growth in earnings came from the operating business.

This year I think the underwriting gain will flatten and then decline, operating companies will remain strong but not as strong as last year, and that the story this year may be derivatives. In last year's first quarter Berkshire listed $354 million in derivative gains, and $447 million in investment gains, but this Year there is the potential for larger gains in derivatives. The annual report listed Warren's derivative positions on page 40 and one of those was described as credit default obligations with the notational value of $2.5 billion. Warren's explanation;

"I should mention that all of the direct currency profits we realized have come from forward contracts, which are derivatives, and that we have entered into other types of derivative contracts as well. That may seem odd, since you know of our expensive experience unwinding the derivatives book at GenRe and also have heard me talk of systemic problems that could result from the enormous growth in the use of derivatives. Why you may wonder, are we fooling around with such potentially toxic material.

"The answer is that derivatives, just like stocks and bonds are sometimes wildly mispriced. For many years, accordingly, we have selectively written derivative contracts, few in number, but sometimes for large dollar amounts. We currently have 62 contracts outstanding. I manage them personally and they are free of counterparty credit risks. So far these derivative contracts have worked out well for us, producing pre-tax profits in the hundreds of millions of dollars (above and beyond the gains I've itemized from forward, foreign exchange contracts). Though, we will experience losses from time to time, we are likely to continue to earn overall significant profits from mispriced derivatives."

Probably the most "wildly mispriced" derivatives last December, were credit default swaps on the lower truancies of mortgage backed securities containing subprime mortgages. If this is the toxic material Buffett has been playing with Berkshire could have a very happy quarter indeed. In view of the fact that there has been practically no discussion of these derivative positions, the results will come as a very large surprise on Wall Street.

Of course, we don't know what CDO's Buffett has been buying or even that he is buying. CDO are basically insurance against a default on a credit instrument, and he could be selling this insurance. However, given the conditions of the market at the end of 2006 and knowing Buffett's nature, I find this highly improbable.

There are other derivatives listed on page 40 (equity options= $21.3 billion, Interest rate and foreign currency swaps= $10.9 billion, foreign currency forwards= $1.0 billion, foreign currency options= $1.0 billion; and interest rate option= $3.1 billion

As you can probably tell I am getting way beyond my circle of competence, and I am sure that there are people here that understand derivatives better than I do, so I have some questions about Warrens derivative list on page 40.

1. For instance, with the credit default of obligations. Is there any way to tell whether he is buying or selling?

2. Does the $952 million listed under liabilities mean that he lost this much in that position last year?

3. With $2.5 billion of notional value in credit default obligations, do you think these are credit default swaps on subprime debt? If they are, how much could they have made on these in the First quarter?

4. With the equity options is there any way to tell whether he is buying or selling? We know that he was writing index puts last year. But is it possible that this entry might include the buying of index puts similar to ones that he purchased in 2000?

Clearly we can only guess what investment and derivative gains will be in the quarter but the potential is there for this number to go above what that they were running last year. In any event, if I were a betting man, and if I were inclined to do short term trades. (Who me?) I would be more inclined to look for a positive surprise in first-quarter than a negative one.

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