2009: Crazy prices for Berkshire's credit default swaps

WARREN BUFFETT: I will — I can’t resist pointing out one item that is, maybe, a little technical to most of you. But there are some people here who will find it quite interesting. And it actually even enters into credit ratings to a great extent, the credit default swaps enter into it.

When we write a, let’s take an equity put option, and we get paid for writing a billion dollar put, somebody pays us $150 million, we get the $150 million of cash that day.

And we set up a liability for 150 million the first day, for the value or the — that we — our appraisal of what it’s going to cost us to meet that obligation. I mean, that’s the market price for it.

The other guy takes 150 million out of his cash and sets up a $150 million receivable that day.

Now, these receivables and payables change over time. But the first day, no profit, no loss, just cash changing hands. One guy sets up an asset, the other guy — we set up a liability.

Now, as the world has developed in the last couple of years, the value of that asset to the other fellow has increased in a mark-to-market basis.

And he reports that through earnings. So his asset goes up. Our liability goes up. And we report that through earnings as a loss.

But we’ve got the cash and he’s got an asset from us that comes due in 15 years or something like that.

And in the last couple of years, the — his auditors — his credit department — has said, “Gee, you’ve got a receivable from Berkshire that comes due in 15 years. And, they don’t have to post collateral. So you have to go out and buy a credit default swap to protect yourself against that receivable going bad.”

Now, that has two effects. A, he’s laying out money every year to buy something that doesn’t cost us anything but costs him real money. So the — and the more he shows us a profit, the more of the credit insurance he has to buy, so the more money it costs him every year.

And that has driven up the demand for credit default swaps at Berkshire, which made for some crazy prices. So at one point, our credit default swaps were costing that guy five percent a year.

So if he was showing, say, a $200 million asset, he was laying out $10 a year, and he was going to have to lay it out for 15 years, just because of these — this credit department’s requirements.

And it made it very unpleasant for the people on the other side of our transactions, even though they keep writing up the profits. It doesn’t cost us anything. But it does result in kind of a crazy market in the credit default swaps.

I realize that that has not been a burning issue with many of you. But it is an unusual — it’s something I didn’t anticipate.

And it explains why, to some extent, people may want to modify their contracts with us. And if they — with us — and if they want to modify them enough, we’ll answer the phone. But in the meantime, we’re sitting with the money. (Laughter)