March 1, 2008 / 2:35 AM / 10 years ago

Buffett makes $40 bln bet on derivatives

NEW YORK, Feb 29 (Reuters) - Warren Buffett’s Berkshire Hathaway Inc (BRKa.N) (BRKb.N) ended 2007 with $40 billion of exposure to derivative contracts designed to make money if junk bonds stay out of default and stock indexes rise.

Berkshire’s maximum exposure under derivative contracts rose from about $24 billion a year earlier, according to the company’s annual report released on Friday. In his shareholder letter accompanying the report, Buffett said the exposure was tied to 94 derivative contracts, up from 62 a year earlier.

The exposure may seem curious given Buffett’s proclamation in his shareholder letter five years ago that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Berkshire also spent about five years extricating its General Re Corp reinsurance unit from its derivatives business -- one Buffett knew about when he bought that company.

But Glenn Tongue, an investor at T2 Partners LLC in New York, said the risk of Berkshire’s derivative contracts is low, in contrast to risks posed from other complex instruments.

He pointed to MBIA Inc (MBI.N) and Ambac Financial Group Inc ABK.N, bond insurers that found trouble after guaranteeing debt, including some tied to subprime mortgages, that now suffers from deteriorating credit quality, falling prices, and illiquidity.

“Berkshire has derivative contracts where it has been paid, and there is no counterparty risk,” he said. “In the case of MBIA and Ambac, there is both counterparty risk with their reinsurance contracts, and their exposure to structured products. Berkshire doesn’t have that.”

Buffett said Berkshire has written 54 derivative contracts requiring payouts if some high-yield bonds default between now and 2013. He said Berkshire has received $3.2 billion of premiums and paid out $472 million, a number he said is certain to rise. The maximum further loss is $4.7 billion, he said.

The other contracts concern put options Berkshire wrote on the Standard & Poor's 500 .SPX and three foreign stock indexes. Buffett said these require payouts only if, when the options expire between 2019 and 2027, the indexes are below where they were when the options were written. Berkshire has received $4.5 billion of premiums, and recorded a year-end $4.6 billion liability, Buffett said.

Berkshire said it lost $89 million from derivative contracts in 2007, reflecting a $62 million gain tied to foreign currencies and $151 million of losses elsewhere.

Buffett said shareholders should be prepared for larger gains and losses, which could “easily” top $1 billion in a given quarter.

Yet Buffett manages Berkshire for the long term, and said he isn’t bothered by short-term bumps in the bottom line. He has said, for example, he’s willing to risk a $6 billion insurance loss from a single storm.

“You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run,” Buffett wrote. “That is our philosophy in derivatives as well.” (Additional reporting by Dan Wilchins; Editing by Braden Reddall)

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