Buffett Climbs From Derivative Hole That Swallowed Berkshire AAA

Berkshire Hathaway Inc.'s Warren Buffett
Warren Buffett mingles ahead of the Berkshire Hathaway Inc. annual shareholders meeting in Omaha, Nebraska, on Saturday, May 2. Photographer: Daniel Acker/Bloomberg

Warren Buffett’s derivatives wagers sapped earnings during the financial crisis at his Berkshire Hathaway Inc. and were part of the reason the company lost its triple-A credit rating. Things are looking rosier now.

Liabilities on the contracts shrunk to $3.5 billion on March 31 from about $15 billion six years earlier. Some of the derivatives are long-term bets that equities will rise, while others protect bondholders against losses if borrowers fail to meet their obligations.

Liabilities on Berkshire Hathaway's derivatives have shrunk
Liabilities on Berkshire Hathaway's derivatives have shrunk

Surging stock indexes in the U.S., U.K., Europe and Japan and a stronger dollar have helped reduce the liabilities on the equity-linked derivatives for years. The improvement accelerated in the first quarter, helping profit climb 9.8 percent to $5.16 billion, according to a company report Friday.

“Unless the world falls apart over the next couple of years, it’ll be another bet that he’s won,” said Meyer Shields, an analyst at Keefe Bruyette & Woods.

It didn’t always look that way. Liabilities on the derivatives ballooned during the financial crisis and contributed to a first-quarter loss in 2009. Moody’s Investors Service and Fitch Ratings cited the contracts when they stripped Berkshire of its top credit grade that year.

The large derivatives book seemed at odds with Buffett’s earlier statements. In 2003, he called them “financial weapons of mass destruction,” a phrase that would later be cited during the credit crisis that forced some of the nation’s largest banks and American International Group Inc. to take government bailouts.

Collateral Damage

Buffett spent more than four pages of his annual report in 2009 discussing derivatives and saying that his deals were different. He wrote that Berkshire was paid for taking on the risk, gets to invest the funds in the meantime, and rarely has to post collateral on the contracts, which won’t be settled for years.

In 2010, Berkshire lobbied members of Congress to exempt previously written arrangements from new collateral rules. Lawmakers eventually decided to grandfather existing derivatives.

Even as Berkshire’s liabilities have shrunk, the wagers remained a fascination. The Financial Times wrote an eight-part series, starting in 2013, about Berkshire’s derivatives tied to stock market indexes and how some of the contracts were more exotic than previously thought.

Buffett, 84, settled some credit-default contracts in 2012. Remaining deals will probably just run out over time, Buffett said at Berkshire’s annual meeting May 2 in Omaha, Nebraska. It’s unlikely that he and the counterparties could agree on a mutually acceptable price to settle them, he said.

Stocks, Bonds

Buffett’s patient approach on derivatives fits with his broader strategy of holding investments for years and paying little attention to short-term fluctuations. And he’s advised shareholders to think of quarterly changes in the liabilities as noise.

Berkshire received $4.9 billion in premiums through 2008 tied to equity-index puts. The contracts expire between June 2018 and January 2026; other deals pertain to debt with maturities from 2019 and 2054.

Buffett never won back the top credit grades. Berkshire is rated Aa2 and Moody’s and AA at Standard & Poor’s.

Since the financial crisis, Buffett has expanded his company through some of his biggest acquisitions. He bought railroad BNSF in 2010, added to Berkshire’s energy utility business and partnered with buyout firm 3G Capital to take over ketchup maker H.J. Heinz. Even if liabilities on the derivatives soar again, they probably won’t have as outsize an effect on Berkshire’s results, said KBW’s Shields.

“They’ve gotten small,” he said. “And Berkshire has gotten bigger.”

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