Ever since Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) reported earnings earlier in the month, a number of people have been abuzz about the “losses” generated from marking-to-market some of the derivatives on the books. Barron’s had a Q&A with short hedge fund manager Doug Kass (one of my favorite contrarian voices) where Kass said he was short BRK because of Buffett’s “investment-style drift,” which has led him to take large positions in derivatives instruments - which he famously derided as “financial weapons of mass destruction” in his 2002 letter to shareholders. And while I’m not sure of his positioning, Mish Shedlock echoed similar thoughts, saying that Buffett’s mark-to-market derivatives loss has given him “$1.2 billion less to invest because so far he is underwater on his short…”
I think Kass and Shedlock are taking their bearish act too far – perhaps because they are doing some unconventional style drift of their own and backing off their normally-sharp research. As Buffett notes in the section of his letter dealing with derivatives, the term “covers an extraordinarily wide range of financial contracts” and range from simple puts, calls, and futures to exotic agreements on any number of reference points, such as total return swaps. Actually reading the two-plus pages of Buffett on derivatives, it becomes clear that the concern centers on long-lived or extremely complex contracts that need to be marked-to-model, allowing for fudging profitability. Buffett isn’t talking about the simple derivatives contracts that Buffett has been increasing Berkshire’s involvement in – namely equity index puts and credit default swaps. I don’t have any explanation why so many people get this wrong, other than to assume they didn’t actually read the relevant passage.
My other problem here is namely with Shedlock’s depiction of the consequences of a mark-to-market loss. Berkshire’s credit rating means it does not have to post collateral on its equity index put, so taking the mark-to-market loss is simply an accounting item – especially when viewed in the context of a derivative with more than a decade until its value will be realized.
At other times, such as when talking about credit default swap writer Primus Guaranty (PRS), I’ve said that mark-to-market losses have minimal meaning for highly rated entities with a long-term horizon. This is true for Berkshire as well, and they say so in their last SEC filing:
Derivative gains and losses in the preceding table primarily represent the non-cash (or unrealized) changes in fair value associated with derivative contracts that do not qualify for hedge accounting treatment… Management does not view the periodic gains or losses from the changes in fair value as meaningful given the long term nature of the contracts and the volatile nature of equity and credit markets over short periods of time.
In other words: Berkshire didn’t really “lose” $1.2 billion cash on its derivatives book.
If Kass is going to be right in his BRK short, it is going to be because insurance underwriting enters a period of decline – something Buffett indicated was bound to happen as more capital entered the space. Doing a quick survey of some sell-side research reports for the sector shows a lack of enthusiasm for the space as a whole, leading to a “in a tough/softening environment” qualifier being attached to fairly good results from a company like Markel (NYSE:MKL). Ultimately, however, I find it hard to believe that Kass can’t find a better short allocation than Berkshire – it just doesn’t seem like a high-probability bet over any extended time period. David Enke makes a good argument in favor of Berkshire.
If you're looking for a play on this confusion, I believe Primus (PRS) is widely misunderstood by investors.