Warren Buffett (Trades, Portfolio) has repeatedly made it clear that he does not like financial derivatives. Indeed, in his 2002 letter to investors, the Oracle of Omaha declared:
"We try to be alert to any sort of mega catastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
However, despite holding this view, Buffett has made heavy use of derivatives over the past few decades to take advantage of what he has called "mispriced" opportunities in the market.
This trading activity shouldn't come as a surprise to Buffett watchers. In the past, the CEO of Berkshire has placed trades on a whole range of financial instruments to take advantage of price arbitrage.
Some of these, such as his substantial silver trade, go against his previous advice. Buffett has always advised against buying gold, for example. Nevertheless, when he sees an opportunity to make money, Buffett is more than happy to bend his rules.
Mispriced securities
That's not to say that the Oracle of Omaha is happy to break the rules whenever. He will only place a trade if it offers an attractive return for the risk taken on, and that's precisely what these derivative positions provided.
Buffett explained his thinking behind the position in his 2008 letter to Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholders:
"Considering the ruin I've pictured, you may wonder why Berkshire is a party to 251 derivatives contracts...The answer is simple: I believe each contract we own was mispriced at inception, sometimes dramatically so.
...
Our derivatives dealings require our counterparties to make payments to us when contracts are initiated. Berkshire therefore, always holds the money, which leaves us assuming no meaningful counterparty risk. As of yearend, the payments made to us less losses we have paid – our derivatives "float," so to speak – totaled $8.1 billion. This float is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time."
When asked about these positions in an interview on the financial news channel CNBC soon after this letter was published, Buffett stated:
"I–well, we've used derivatives for many, many years. I don't think derivatives are evil, per se, I think they are dangerous. I've always said they're dangerous. I said they were financial weapons of mass destruction. But uranium is dangerous, and I just went through a nuclear electric plant about two weeks ago. Cars are dangerous.
But I mean, every American wants to have one. You know, the–a lot of things can be dangerous, but generally, we regulate how they're used. I mean, there was a–there was some guard up there with a machine gun on me, you know, when I was at the nuclear plant the other day. So we use lots of things daily that are dangerous, but we generally pay some attention to how they're used."
Risk vs. reward
It seems that Buffett was saying that derivatives can be powerful instruments if they are used conservatively and correctly, instead of using them like chips in a casino.
In his 2008 letter to shareholders, Buffett explained that for Berkshire to lose all of the $37.1 billion at risk, the four major stock indexes covered (the S&P 500 in the U.S., the FTSE 100 in the UK, the Euro Stoxx 50 in Europe and the Nikkei 225 in Japan) would have to go to zero by 2028.
The likelihood of that happening is very, very low. Even if the indices fell by 25%, Berkshire would be on the hook for "$9 billion, payable between 2019 and 2028." However, it would have held the $4.9 billion premium and earned investment income on it over the same time frame.
So, while derivatives can be financial weapons of mass destruction, Buffett's decision to take advantage of these mispriced financial contracts has earned Berkshire shareholders billions of dollars of extra income over the past decade.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Learning From Charlie Munger's Investment Approach
- Lessons From 'The Super Investors of Graham-and-Doddsville'
- Why Warren Buffett Decided to Launch Berkshire's B Shares
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