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Monday, May 18, 2009

Buffett Restructures Derivatives Bet To Take On More Risk


May 17, 2009

WHEN Berkshire Hathaway shareholders descended on Omaha earlier this month for their annual meeting -- the value investor's equivalent of a pilgrimage to Mecca -- one of the hottest topics of conversation was the $37.1 billion bet that the company had made on options tied to global stock prices two years ago.

Although Warren Buffett is famous for his portrayal of derivatives as "weapons of mass destruction," that didn't stop him from selling one type of derivative -- "put" options on the S&P 500 and other major indices -- an investment that is now heavily underwater after the dramatic downturn in the stock market since mid-2007.

During the conference, Berkshire executives let it be known that the firm had recently restructured its option positions, making new bets that would, in essence, pay off if stocks rebounded about 15 percent over the next decade -- instead of the original contracts, which would have required the S&P to climb over 70 percent in the next 18 years to break even.

In recent weeks the chatter along the derivatives "rat line" has been full of rumors about the new Berkshire trades. According to traders active in the options pit, when Berkshire sought to restructure its bets (essentially buying back the multi-decade options it was short and selling new, shorter-duration options that are closer to current stock price levels) it could do so only by paying a heavy cost, since the original positions were so deep in the red.

According to these sources, this restructuring was accomplished on a "dollar neutral" basis, meaning that Berkshire didn't have to pony up cash to do the trade.

Like a gambler doubling down on credit, Berkshire instead purportedly sold a significantly larger number of short-dated contracts than the original transaction -- meaning that the potential risk of loss to Buffet and his shareholders over the next 10 years has actually increased, but only if the markets were to decline from current levels and remain there.

Sources also say that Berkshire was squeezed more on the pricing this time around since the company's credit is not quite as pristine as it was two years ago.

Berkshire Hathaway didn't respond to two e-mails seeking comment.

If the rumors are true, the trades will be detailed in the company's next SEC filing -- but we will have to wait until 2020 to see if the bets pay off.

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