Warren Buffett’s Letter to John Dingell Circa 1982
Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories.
First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.
We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in “Derivative Contract Liabilities” on our balance sheet.
The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.
Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.
Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.
Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. 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. That is our philosophy in derivatives as well.
That’s an awful lot of exposure to derivatives. Once, Warren Buffett famously called derivatives financial weapons of mass destruction. Where does he stand on this now? He could have argued that standard index derivative contracts are kosher before we saw this letter from 1982 below. Buffett lobbied Congress for tighter restrictions on derivatives. Now, perhaps because of his large derivatives position, he is lobbying for looser restrictions. Either he has changed positions or we are witnessing a serious case of hypocrisy here.
In Buffett’s defence, I would say that he argued in 1982 that a short position in index derivatives could be a legitimate hedge, while it is the long side which is the speculation. Berkshire doesn’t have a short position in the S&P contracts though. It is selling puts, which is effectively a long position i.e. Buffett appears to be gambling that the S&P 500 will not fall below a certain level over a certain time frame. At least in selling puts the downside is limited, but it is still a gamble and not a legitimate hedge.
In any event, the derivatives are exactly the reason S&P stripped Berkshire of its AAA rating. I expect we will hear a lot more about this in the coming weeks.
Buffett Letter to John Dingell 1982
Edward:
Question on a little historical context: What was Buffet responding to in 1982 to Dingle, why the letter?
P.S. Thanks for all the work and great postings.
Buffett was responding to proposed legislation that became the Shad-Johnson Accord which was repealed in 1999 with the Commodities Futures Modernization Act.
Here’s an article on the CFMA:
https://www.derivativesstrategy.com/magazine/archive/1999/0999regwf753.asp
When the Chicago Board of Trade began trading futures on the Dow Jones Industrial Average in 1997, it made it clear to everyone listening that once the DJIA products took off, futures on other Dow Jones indices would follow.
Last year, the CBOT tried to implement that strategy by petitioning regulators to list futures on the Dow Jones Utilities and Transportation Indices. Under the 1982 Shad-Johnson Accord, futures exchanges wishing to list stock index futures must first get a green light from the Securities and Exchange Commission before petitioning the Commodity Futures Trading Commission for ultimate approval.
The CBOT’s plans were quickly derailed when the SEC rejected the products, arguing, among other things, that the indices involved were too narrow and thus were prone to manipulation, which could add volatility to the underlying market. This has been the SEC’s tireless refrain whenever asked to comment about possible amendments to the Shad-Johnson Accord or the Commodity Exchange Act itself.