Warren Buffett once famously labeled derivatives “weapons of mass destruction” due to the highly-leveraged nature of the contract structure and its ability to literally destroy the economic foundations of a society. The over the counter (OTC) derivatives exposure is said to be near $600 trillion, capable of wiping out the economic value of the world economy, valued at $72 trillion, several times over.  The exact derivatives exposure is unknown because, until recently, these contracts were not transparent and traded off exchange in privately negotiated contracts, the subject of a twenty year battle in Washington D.C.

warren buffett Mr Buffett the Teacher

This is one reason a recent FT commentary that cited Buffet’s apparent lack of disclosure regarding his firm’s exotic derivatives holdings is so interesting.  But perhaps even more interesting, and not cited in the article, is when one further connects the dots to recent revelations that Buffett’s firm, Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B), was recently deemed systemically significant, meaning that it could qualify for a government bailout if their risky derivatives bets turned into losers.

In the FT article author Dan McCrum cites work with Professor Pablo Triana that questioned as improper Buffett’s disclosure of a derivatives position from 2004 to 2008, which was lightly disclosed in the 2009 annual report on page 84.

That article notes that when valuing traditional exchange traded options, where the contract specifications, terms and fees are standardized and transparent, the accounting for such contracts is rather straightforward.  But Professor Triana notes that in their disclosure “Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)’s commentary and disclosure has always indicated that the contracts are of the plain vanilla variety.”

Buffett using lightly disclosed “weapons of mass destruction”

According to the disclosure, Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) sold put options on stock indices, known in the managed futures industry as a risky volatility trading strategy that has a high win percentage but can literally overwhelm a fund with losses far greater than capital reserves when a market crashes and moves against the position.  Prof. Traina cites a Lehman Brothers presentation that outlines the purchase of a “worst-of” put basket from Berkshire in 2007.  A worst of put basket in this case was essentially a bet on three stock indices, and only pays on the option that is most profitable.  While the payout structure is unusual, what is most interesting to derivatives professionals is that the contract was an individually negotiated off exchange and did not require the posting of collateral.

For the trade Berkshire collected $5 billion in upfront option (insurance) “premium,” which is the cap on the trade’s upside potential.  The notional value of the contracts traded was near $50 billion, but this is not necessarily the limit to Berkshire’s loss potential and the lack of disclosure only obfuscates the issue, the report notes.  “As there is very little collateral associated with these, and Buffett claims to be uninterested in the effect of mark-to-market valuation changes on Berkshire’s earnings, they have perhaps received less attention than they might. But the work detailed the various inputs to option valuation, and showed that an outside observer might have expected big falls in interest rates and index values to substantially move the valuation against Berkshire.”

Details unclear, which is typically the case in OTC derivatives

In short, it appears as though the potential liability listed in the annual report doesn’t tell the full story. “It seems odd that put liabilities would be just $10 billion in Q4 2008 and Q1 2009. Contracts that had cost $4.9 billion during 2004–Q1 2008 (very calm period generally, low volatility, ever-rising stock prices, ever increasing interest rates, the “great moderation”) were now worth just a bit over twice that amidst incredible, historically unprecedented volatility and dramatically tanking markets (well below strike prices) — causing much lower interest rates,” Prof Triana wrote.