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Berkshire Hathaway: We Did Not "Goof" on Derivative Risks

Friday, 14 Aug 2009 | 1:33 PM ET
Bewrkshire Hathaway: What's the Risk?
Bewrkshire Hathaway: What's the Risk?

Berkshire Hathaway isn't happy with a Reuters story initially published with the headline, "Buffett's Berkshire: We Goofed On Derivative Risks."

(CNBC.com's headline when it ran the same Reuters story was Berkshire Stands By Valuation Of Its Derivatives Contracts.)

The article is based on a June 26 letter from Berkshire to the SEC in which Warren Buffett's company discusses how it calculated the current value of billions of dollars in equity index put option contracts it has written.

Berkshire CFO Marc Hamburg tells Warren Buffett Watch, "There is no indication whatsoever in my letter to the SEC that we made an error or that we underestimated the risks of falling stock prices."

The SEC had asked Berkshire how it determined "weighted average volatility," one of the assumptions that goes into a formula for estimating the current value of long-term option contracts.

The contracts are essentially insurance policies that protect buyers against the possibility that four global stock indexes will lose value between the time the policies were written and the time the policies expire. Those expirations are far in the future, between 2018 and 2028.

Even though Berkshire won't have to pay any claims until expiration, the company must come up with a current "mark to market" value for the contracts, and include that "paper" gain, or loss, in its earnings reports.

(About $1.5 billion in derivatives gains helped push Berkshire's net into the black for the second quarter.)

The SEC asked why the volatility figure used by Berkshire in 2008 was "relatively unchanged" from the 2007 figure, given the big declines in stock prices during the year.

In its letter, Berkshire replies that its volatility assumption is "based upon the implied volatility at the inception of each equity index put option contract" and promised to disclose that method in future filings.

The letter continues:

"We recognize that the index values of the four indexes declined between 30% and 45% at December 31, 2008 as compared to the prior year end index values. Even though these short-term declines are in excess of our volatility inputs, we continue to believe that our volatility inputs are reasonable given the long-term nature of our equity index put option contracts which have contract expiration dates between 2019 and 2028."

Reuters translates "even though these short-term declines are in excess of our volatility inputs" into Berkshire "underestimating the risks of falling stock prices to its billions of dollars of derivatives bets," implying that Berkshire is admitting a mistake or error (or "goof.")

But there's nothing to admit.

Volatility in one year may have been higher than the company expected, but that's just for one year. Berkshire is estimating volatility over the life of the contracts, which is measured in many years. Berkshire says that long-term estimate is still "reasonable."

It was never forecasting volatility in any one year, so one unusually volatile year doesn't, on its own, mean that Berkshire "underestimated the risks" .. over the long-term.

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