Spring Cleaning (of the Mind)

Every spring, I get to do some mental housecleaning from reading the witty, but sober words of my hero - Warren Buffett. Recently, a friend commented that all our heroes let us down. I replied that mine hasn't.

The 2005 Berkshire Hathaway (BRK) annual report had its usual share of good humor and business insights. In rereading old BRK reports, I have noticed a pattern. In commenting on large scale issues, such as inflation or interest rates, I have found his outlooks as prone to inaccuracy as the rest of us. However, on issues of narrower scope, he has an amazing record.

So when he criticized the derivatives business, I sat up in my chair. He writes "We lost $104 million pre-tax in our continuing attempt to exit Gen Re's derivative operation. Our aggregate losses since we began this endeavor total $404 million." His words warrant some reflection and, probably, alarm.

BRK purchased Gen Re on December 21, 1998. Gen Re has a subsidiary that operates as a dealer in the swap and derivatives market. I have prepared the following chart to highlight the derivatives issue as it develops for BRK since the time of the Gen Re purchase:

...........# Of "Derivative"..Remaining.....Mlns of $
Year ........Mentions .........Contracts....... Losses

1998 ............0
1999 ............0
2000 ...........11
2001 ...........16........................ 23,218
2002 ..........53.........................14,384...............$173
2003 ..........32..........................7,580................$ 99
2004 ..........25..........................2,890................$ 28
2005 ..........63.............................741................$104

Mr. Buffett admitted that he did not understand the depth of the Gen Re derivatives problem. His initial idea was to just sell that part of the business, but, he found that derivatives are like Hell - easier to get into than out of.

For the novice reader, let me explain. Derivatives are contracts designed to transfer a specific risk for a certain period of time. For example, I might want to transfer the risk of my shipping company going broke to someone who may view that company as creditworthy. We could use a contract to accomplish this, called a "derivative" because it derives its value from something else - here the supplier's financial situation.

Because such contracts are so specific, they are mostly illiquid. This lack of liquidity creates enormous latitude for valuation. Since there is no ready market for the contract I have listed as an example, both the buyer and the seller (in this case, me) could estimate the contract's value. Human nature being what it is, both sides will typically find a method to value it a profit.

Mr. Buffett found that the listed values did not equal those he really found in the marketplace. By 2002, BRK had worked on selling these contracts for four years, managing to reduce the number of such contracts to 14,384 from 23,218 while realizing a loss of $173 million (in effect, paying someone else to take those contracts). In the 2002 annual report, Mr. Buffett reflected this frustration, describing derivatives as "time bombs" and "financial weapons of mass destruction." This is strident language for someone not prone to emotional overstatement.

Three years years later, (economically, very good ones) he reports that, despite continuing his best efforts, losses have piled up and are not over yet. BRK still holds 741 contracts. Clearly, these contracts are exit-challenged.

If this astute investor (arguably the best) is unable to extricate himself from derivative issues, how do the rest of us avoid getting in?

Some clues may be provided by this year's annual report. We have to assume that his current investment decisions reflect his desire to avoid "derivative" problems. However, Mr. Buffett increased BRK's ownership of Wells Fargo (WFC) from 56.448 million shares in 2004 to 95.092 million shares in 2005. A quick survey of the 2004 WFC annual report reveals heavy use of derivatives, mentioning them 106 times. Why wouldn't he avoid such exposure?

As we saw from the example above, there are basically three types of derivative users: sellers - who want risk transferred, buyers - who want to take on risk and brokers - who get paid to match sellers and buyers. The use of derivatives is very similar to insurance - both are contracts designed to transfer risk. Since WFC is a heavy user of derivatives, but almost exclusively to transfer the risks away, Mr. Buffett views them positively. Are there areas that would be mean greater risk?

Here a clue may be in Mr. Buffett's comparison of derivative contract issuance to providing reinsurance. Basically, Gen Re used derivative contracts as another line of reinsurance. In fact, a review of other reinsurance company annual reports reveal "unhedged" uses of derivatives, meaning that reinsurance companies take on risk and income is the equivalent of insurance premiums. Interestingly, the mention of "derivatives" is much lower (between 5 and 25 times). Other insurers are more complex.

Most insurers use derivatives as WFC does - as a hedge. However, AIG uses them both ways. AIG makes a distinction between its operations that use derivatives in a hedging sense and those that don't. AIGFP, a subsidiary, would qualify as a candidate for some of these derivative-related problems pointed out by Mr. Buffett.

Finally, the brokerage houses are the most complex, but not necessarily the most risky. The mention of "derivatives" moves to a new high - as many as 265 mentions in the annual report of J.P. Morgan Chase (JPM). However, analysis of these mentions shows some positives and negatives. While the exposure is much higher, the exposure is as a broker, not as the taker of a risk. By having a such a high level of derivatives (notionally $41 trillion), there is greater systemic risk, although not as much company or contract specific risk.

From the 2005 annual report, good "spring cleaning" would avoid whereever derivatives increase risk (and income), but to include those areas where derivatives reduce risk.