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2009: Are large derivative positions appropriate for a highly-rated insurance company?
CAROL LOOMIS: So, my first question, “Warren and Charlie, Warren particularly.
“You have referred to derivatives, this is famous, as weapons — financial weapons — of mass destruction.
“In the 1964 movie, ‘Dr. Strangelove,’ Major T.J. Kong, nicknamed ‘King’ Kong and played by Slim Pickens, rides a weapon of mass destruction out of the bomb bay of his B-52.
“As a long-term Berkshire shareholder, I’m feeling a little like Slim today. I understand that despite the dramatic decline in the stock market, there is a good probability we could make money on our derivatives, taking into account the return on our premiums.
“But given the amount of accounting equity and statutory capital, and, I would argue, market value —” this is the questioner saying this — “that these derivatives have destroyed, at least temporarily, do you think these large derivative positions are appropriate for a highly-rated insurance company?
“And if so, you do you think you will be adding to these positions?”
WARREN BUFFETT: Yeah. I would say this. The questioner to some extent answers his own question.
I don’t know whether he anticipates as strongly as I do that, net, these positions will make money.
But over — you know, our job is to make money over time at Berkshire Hathaway. It does not impinge on capital. We have arranged them so that the collateral posting requirements, which are one of the big dangers in the derivatives field, that we have very, very minimal exposure to that.
Even on March 31st, at a time when the market was down very substantially from when we entered into these transactions, we had posted collateral of a little less than 1 percent of our total marketable securities.
So they have no — they pose no — they pose problems to the world, generally. And that’s why I referred to them on a macro basis, in the 2002 report, as being financial weapons of mass destruction.
But I also said in that report, that we use them in our own business regularly when we think they’re mispriced.
And we think our shareholders are intelligent enough that if we explain the transactions, as we try to do in the annual report, and explain why we think we will make money — there’s no guarantee we’ll make money, but our expectancy is that we will make money — we think that as long as we explain them, that the financial consequences to our shareholders far outweigh any accounting consequences.
We explained in earlier reports that because of mark-to-market, that these things can swing billions of dollars as an accounting liability.
But the only cash that has taken place, for example, in our equity put options, we have received $4.9 billion roughly. And we hold that money. Originally, the terms of these were 15 to 20 years. So we have the use of $4.9 billion for 15 to 20 years.
And then markets have to be lower at that time than they were at the time of inception. So I personally think that the odds are extremely good that on the equity put options, we will make money.
I think on the high-yield index, credit default swaps we’ve written, I think that we will probably lose money before figuring the value of the money we’ve held.
Now, I told you a year ago, I thought we would make money on those. But we have run into far more bankruptcies in the last year than is normal.
We’ve, in effect, had a financial hurricane. We insure against natural hurricanes. And we insure against a financial hurricane. And we have been in a bit of a financial hurricane.
So I would expect those contracts, before investment income, would show a loss, and perhaps, after investment income. The bigger contracts are the equity put contracts. And I think the odds are very high that we make money on those.
Now, it would be nice if we were writing with current prices. But we probably couldn’t write them without getting into collateral posting requirements now. So we have a very favorable position on those.
In fact, in the last week, we modified two equity put contracts, one that had a strike price of 1514. That has been reduced to 994 on the S&P 500. Now, we shortened it up eight years. But it still has about 10 years to run.
So merely for reducing the term from 18 years to about 10 years, we still have the use of the money for 10 years, we reduced the strike price from 1514 to 994.
So I think those are going to be very advantageous contracts. I think our shareholders are intelligent enough to, if they’re explained properly, to realize how advantageous they are. And we’ll continue to hold them. And we’ll continue to explain them.
And they have no impact on our financial flexibility. And we are far more than an insurance company. I mean, we have earnings coming in from many areas. We have lots of cash sitting at the parent company. We have lots of cash in the subsidiaries. We have no significant debt maturities of any kind.
So we’re ideally suited to hold this sort of instrument.
And Charlie, what would you say?
CHARLIE MUNGER: Well, I would agree with the questioner that there is some limit to the amount of those things we should do. But I think we stayed well short of the limit.