INSIGHT-Buffett gets in a bind over options

PAPER LOSSES

Berkshire Hathaway has said its options reference four major equity indices; the S&P 500 .SPX, the FTSE 100 .FTSE, the Euro Stoxx 50 .STOXX50E and the Nikkei .N225.

Buffett has said the contracts are known as European-style put options, meaning Berkshire would only have to make payments when the contracts expire -- and even then, only if the indices are below where they started.

The contracts are valued using a model Buffett has criticized, which estimates the riskiness of the options based on historical market fluctuations, known as volatility.

At the end of the first quarter, Berkshire had $36.76 billion at risk through these trades. For a graphic of his liabilities from the options, click on link.reuters.com/zyw33n

That is, if all four indices fell to zero at the contract expiration date, Berkshire would have to pay $36.76 billion.The options, entered between 2004 and 2008, had maturities of 15 or 20 years, Berkshire has said.

Those four indices dropped between 11 and 15 percent in the second quarter. Over the same period, the Chicago Board Options Exchange's VIX index .VIX, which uses one-month option prices to indicate expectations of stock market volatility, almost doubled to 34.54 from 17.59.

Option prices generally have been rising as stock market volatility has increased, but the uncertainty over how the regulation will apply to longer-dated options has caused implied volatility for those contracts to spike.

Many investors have interpreted the higher prices as a sign of pessimism about the stock market [ID:nN27108308]. But fear of Buffett unwinding his positions, or even failing to sell new options, may be a big factor, too, experts said.

"If there's no one willing to sell, (the price) is going to go up," Morningstar's Guziec said.

That fear alone could force Buffett to act -- as the market value of the options rises, Berkshire Hathaway may face even more pressure to post collateral or unwind the positions.

CUTTING POSITIONS

Berkshire Hathaway has trimmed risk on the positions before. Buffett last year said that he shortened six of the contracts' maturities and lowered their strike prices -- the index level below which he would have to make payments -- between 29 and 39 percent.

At the end of 2009, the weighted average life of all the contracts was about 11.5 years, Buffett reported.

Cutting the total exposure further by reducing strikes and the length of the contracts could make sense, said Meyer Shields, an insurance analyst at Stifel Nicolaus.

"I don't know that any investors that I've spoken to think that this is the best use of capital."

Shields said the typical Berkshire investor has changed since the company split its Class B shares 50-for-1 in January and joined the S&P 500.

Joining the index meant that certain institutional investors, such as pension fund managers that are required to own S&P 500 stocks, had to buy the shares.

Analysts said that with new shareholders, Buffett could face more pressure to explain the contracts, which add volatility to the company's quarterly statements.

"The last couple of years we've seen that even if these deals all work out in the end, quarter to quarter they may cause a little heartburn," said Clifford Gallant, insurance analyst at Keefe, Bruyette & Woods.

"There are valid reasons for people to be unhappy that these (options) are here," said Gallant. "It brings an element of volatility to quarterly results that I think people don't like... It's not the reason people invest in Berkshire." (Reporting by Elinor Comlay. Editing by Dan Wilchins and Robert MacMillan)