(BRK.A), (BRK.B)
While derivative contracts were viewed by many analysts as ticking time bombs that exploded with devastating consequences during the 2009 recession, Berkshire Hathaway has used them to book huge financial gains over the past three years.
The use of the phrase “time bombs” comes directly from Warren Buffett, who said in Berkshire’s Hathaway’s 2002 annual report that “I view derivatives as time bombs, both for the parties that deal in them and the economic system.”
This has led some investors to have the false impression that Berkshire does not use derivatives, credit default swaps, or other financial instruments.
Not only does Berkshire use them, but it has been using them to add billions of dollars to Berkshire’s coffers.
1st Quarter Billion Dollar Bounty
During Berkshire’s 2015 first quarter, derivative contracts produced pre-tax gains of approximately $1.3 billion. This compares to just $236 million in 2014. In 2015, the gains were primarily related to equity index put option contracts, while 2014 reflected gains from credit default contract exposures, partially offset by losses under the equity index put option contracts. The company notes that the 2015 gains were from equity index put option contracts, and the gains reflected increased index values and the favorable impact of a stronger U.S. Dollar, which reduced liabilities of contracts denominated in foreign currencies.
For all of 2014, derivative contracts produced pre-tax gains of $506 million, and the change in the fair value of their credit default contract during 2014 produced a pre-tax gain of $397 million.
In addition, equity index put option contracts produced pre-tax gains of $108 million in 2014.
As Berkshire has powered out of the recession, its various bets on the U.S. economy, which included the 2009 acquisition of BNSF Railways, have proven savvy. The purchase of BNSF at a time when others were running for financial cover was touted by Buffett as an “all-in wager on the economic future of the United States,” and has proven to be so.
Buffett’s Use of Derivatives Has Paid off
As the economy and the stock market have gained momentum, Berkshire’s various derivatives, options and other financial instruments have made the company bushels of money. For example, in 2013, derivative contracts generated a pre-tax gain of $2.6 billion, including a $2.8 billion gain from equity index put option contracts.
Deactivating the Time Bombs
Berkshire has significantly reduced its total derivatives exposure, reducing it to just$ 3.5 billion at the end of the first quarter. The amount is less than a quarter of Berkshire’s $15 billion derivatives exposure in 2009.
The lesson is that when used prudently, these financial instruments are useful tools. However, like all future promises to pay, you have to have the means to back them up.
© 2015 David Mazor
Disclosure: David Mazor is a freelance writer focusing on Berkshire Hathaway. The author is long in Berkshire Hathaway, and this article is not a recommendation on whether to buy or sell the stock. The information contained in this article should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results.