Despite his warnings against them, Warren Buffett doesn’t completely shun derivatives. He’s sold billions of dollars of them through his Berkshire Hathaway Inc. investment group. And with markets in a mess, he’s taking paper losses. But Berkshire has a huge financial cushion. That and Buffett’s management of investor expectations offer lessons for other mark-to-market sufferers.
First, he keeps that cushion plumped up. Berkshire has written derivatives on stocks and bonds with an underlying value of nearly $50 billion (Rs2.38 trillion). That’s much higher than the derivatives’ market value, which fell an estimated $1 billion in the third quarter, contributing to a 77% decline in Berkshire’s profits compared with a year earlier. But Buffett’s company still made a profit, even with the markets in disarray. So although the final profit or loss on the derivatives won’t be known for years, he appears to have scaled his exposure so that paper losses along the way are highly unlikely to put a big hole in Berkshire’s balance sheet, undermining its other businesses.
Managing expectations: Berkshire Hathaway Inc. CEO Warren Buffett. Matt Sayles/ AP
Second, it helps that Berkshire doesn’t borrow much. The company doesn’t have to post collateral on its derivative positions—provided, among other things, it doesn’t lose its strong credit rating. With little leverage, there’s enough of a buffer that even much bigger paper losses won’t trigger that. American International Group Inc., for one, found out the hard way that a vulnerable credit rating plus huge mark-to-market losses can quickly lead to downgrades and a life-threatening outflow of hard cash.
Third, Buffett has always told shareholders to look beyond quarterly earnings and to keep in mind the somewhat artificial accounting effects at work on both the upside and downside.
By contrast, Wall Street bosses who paid themselves handsomely based on paper gains on the way up have zero credibility when they try to excuse mark-to-market losses. It’s just possible Buffett will still end up losing a lot of real money on his derivatives. But others could learn from his skills in setting the stage so that investors aren’t scared off by paper losses along the way.