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Buffett's Berkshire: We goofed on derivative risks
August 13, 2009 / 5:22 PM / 8 years ago

Buffett's Berkshire: We goofed on derivative risks

* Underestimated degree of stock market decline

* Berkshire disclosure insufficient despite 2008 demand

* SEC closes review without further comment

* Berkshire shares up 1.7 pct

By Jonathan Stempel and Lilla Zuill

NEW YORK, Aug 13 (Reuters) - Warren Buffett’s Berkshire Hathaway Inc (BRKa.N)(BRKb.N) underestimated the risks of falling stock prices to its billions of dollars of derivatives bets, yet still believes it is valuing the contracts fairly.

Berkshire revealed its error in a June 26 letter to the U.S. Securities and Exchange Commission, one of several pieces of correspondence with the regulator about the company’s annual report, and made public on Thursday.

It also agreed to SEC demands for more explanation on $1.8 billion of writedowns on stock investments, and $2.7 billion of auction-rate and other municipal debt holdings. On June 29, the SEC said it completed its review without further comment.

The correspondence shows Omaha, Nebraska-based Berkshire, which has close to 80 businesses and ended June with more than $136 billion of stocks, bonds and cash, is struggling to comply with SEC requirements to disclose enough about its finances.

This issue had surfaced in June 2008, when the regulator demanded “a more robust disclosure” of how the insurance and investment company values its derivatives. Buffett did provide some additional disclosure, in what he called “excruciating detail,” in his annual shareholder letter in February.

Berkshire, through Buffett’s assistant Carrie Kizer, had no immediate comment.

The derivatives contracts are tied to four equity indexes in the United States, Europe and Japan, and are a big reason Berkshire’s earnings fell for six straight quarters. That string ended in the April-to-June period as stocks rebounded.

In the June 26 letter, Berkshire’s Chief Financial Officer Marc Hamburg told the SEC that last year’s 30 percent to 45 percent declines in the equity indexes “are in excess of our volatility inputs.”

He nevertheless said Berkshire’s expectations for stock market volatility are “reasonable” given the long-term nature of the contracts, which expire between 2018 and 2028.

Berkshire ended June with $8.23 billion of paper losses and $37.48 billion of potential liabilities on the contracts.

Buffett expects the contracts to be profitable and can invest upfront premiums as he wishes. This is one reason the world’s second-richest person believes the contracts are unlike derivatives that are “financial weapons of mass destruction.”

The $1.8 billion of “other-than-temporary impair losses” in 2008 related mainly to 12 equity securities that “generally” lost 40 percent to 90 percent of what Berkshire had paid for them, Hamburg wrote on May 22. Berkshire did not write down six other securities that fell 20 percent to 40 percent, he said.

Hamburg also wrote that Berkshire had reduced its stake in auction-rate and similar municipal debt to $2.7 billion at year end from $6.5 billion six months earlier, but that the credit crisis slowed the runoff in the fourth quarter.

The auction-rate market seized up in February 2008 and has not recovered. Berkshire has said it does not plan to sell its auction-rate holdings at below face value and can hold them until they are auctioned off or redeemed.

In afternoon trading, Berkshire Class A shares rose $1,750, or 1.7 percent, to $102,750 on the New York Stock Exchange. (Reporting by Jonathan Stempel and Lilla Zuill; editing by Andre Grenon)

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