Warren Buffett is getting a lot of criticism for a big blunder. He sold put options on four stock indexes – including the S&P; 500.
Buffett described these derivatives in his 2007 letter to shareholders:
“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…”
Financial Weapons of Mass Destruction
Before criticizing Buffett, we need to take a moment to praise him. After all, the guy had the foresight to clean out the General Re derivatives before the credit crisis hit.
Yes, Berkshire took a loss. And, yes, Buffett clearly overestimated both the rationality and morality of the human capital over at General Re – much as he had at Salomon.
Buffett was never well-liked at Salomon. And I’m sure there are some folks (or ex-folks) at General Re who don’t find him quite as avuncular as he is reputed to be.
I would say they simply don’t understand each other, if I didn’t think the truth was exactly the opposite. Buffett got to know Salomon and General Re better with time – and the better he knew them, the less he liked them.
The General Re derivatives were a disaster averted. Had Berkshire kept the book intact or never acquired General Re, we’d be hearing a lot more about what was in that book.
Is it a mere coincidence that Buffett, the CEO who made the decision to unwind the General Re book, called derivatives “financial weapons of mass destruction”?
No. Buffet saw something in that book. And he did something about it. Most CEOs did not.
Enough praise. Back to the blunder:
“Over the past five years, Buffett frequently called derivatives ‘financial weapons of mass destruction’, comparing derivates to ‘hell…easy to enter and almost impossible to exit.’ Yet, he has, very much out of character, immersed himself in a large and, thus far, unprofitable derivative transaction. His investment successes have not been in speculating in the market (something he has been critical of) but rather by purchasing easily understandable companies with dependable cash flows…”
That’s Doug Kass writing lasting year about Buffett’s style drift. He goes on to write:
“It immediately occurred to me after gazing at Buffett’s style drift (manifested in Berkshire Hathaway’s large first quarter derivate losses) that he might be increasingly viewed as the New Millennium’s Ben Franklin, a man who wrote ‘early to bed and early to rise’ but spent many of his evenings in France, whoring all night…”
Not surprisingly, Kass is negative on Berkshire stock. I won’t argue that point. Berkshire has fallen. And short sellers have made money.
Kass presents Buffett’s derivative transaction as “speculating in the market”.
Let me offer an alternate explanation.
Berkshire Hathaway has substantial insurance operations. It is, in fact, a huge insurer of large, often unusual risks. In some cases, Berkshire prefers to keeps such risks to itself instead …Read more