Warren Buffett's Derivative Positions

Berkshire Hathaway recently released its chairman's letter to the shareholders. Chairman Warren Buffett, opposed to many of the absurd and overlevered uses of derivatives, has used derivative positions over several years to take large positions. The most recent letter describes their current contracts which are divided among writing credit default swaps and puts on equity indices and leftover currency positions. Since Buffett has written the credit default swaps and sold the puts, he is able to hold all of the premium upfront and has eliminated his counterparty risk (which can be significant since they are all long-term contracts) and he is able to invest that money with returns greater than the likely implied interest rates in the contracts (either buying companies or pieces of companies). If he has an untimely death, I would hope that his successor can allocate capital as efficiently as Buffett can.

Credit Default Swaps
Berkshire-Hathaway (BRK) holds 54 contracts on specific bonds in high-yield indices. These contracts expire between 2009 and 2013 and BRK has received 3.2 billion, with a liability of .47 billion (and a max of 4.2). Professor Ed Altman at NYU has pointed out that there were practically no defaults in 2007 compared to historic averages (source: his Bankruptcy class). In fact, he estimates that the high-yield bonds will go to 4.64% (ht: FinanceProfessor), significantly higher than it is now. Typically when the economy sours, there are waves of defaults. These contracts are a very good investment given the historic lows and the financial trouble that will be coming.

Selling Puts
40 put contracts were written by BRK on the S&P500 and three other foreign indices. These contracts will last 15 to 20 years and were struck at the market. BRK has received premiums of 4.5 billion with a liability of 4.6 billion. However, these are European puts which means that they can only be exercised at expiration, 15-20 years from now. With inflation at 3% over the next 15-20 years, I see almost no possibility that Buffett will have to pay out any money on these contracts. In that time period, he (and his successor) will be able to invest that money generating large profits for shareholders. However, I do see these markets coming down over the next year or two which will require large liabilities and could temporarily hurt earnings. It's such a good investment (when not levered, which I doubt Buffett would do) in the long-term that they will never actually have to pay out any money. I would ignore any profits or losses they generate in the next five years. These won't be real losses by any stretch.

Currency Swaps
BRK held a currency swap in the Brazilian real in 2007 purchased in 2002 and euro-denominated Amazon.com bonds purchased at something like 57% of par during the internet crash. As the dollar fell, the Brazilian real and the euro have increased in value which have yielded very strong profits for Buffett. In fact, almost half of the profit on his Amazon bonds was due to appreciation of the euro and the bonds are now valued at more than par. However, Buffett is no longer exposing himself to bets on the weak dollar as he has in years past. This seems like a smart play. Real monetary base has been essentially flat or negative for the past year now and most inflation that will be coming will be due more to higher commodity prices (which will come down if the overall economy slows and affects all countries) than due to too much real printing of dollars. Core inflation will likely go lower throughout the year which will give some strength back to the dollar. I would wait to put on any positions shorting the dollar until real monetary base starts cranking up and then I would only do it after looking at the relative monetary policies of the opposite country.

Buffett discusses many other interesting topics in his letter than deserve attention (his analysis of accounting assumptions is always written better than anyone else), but I will confine myself with these three topics.