Berkshire Hathaway’s Derivatives Math

Alan Schram at Seeking Alpha takes some notes at the annual conference of Berkshire Hathaway, the investment firm run by the “Oracle of Omaha,” Warren Buffett. It’s mostly run-of-the-mill stuff, but this passage caught my eye.

Derivatives. The usefulness of derivatives is overrated. They have some utility but have to be conducted safely, under responsible rules. Wall Street should have a socially important purpose, and not resemble a casino, where people are more concerned with valuing an option than valuing a business.

Congress is looking into imposing new retroactive regulation on derivatives (Berkshire has 250 derivative contracts, down from some 23,000 contracts ten years ago, with a notional value of 1 percent of that of some other large institutions).

Even if the bill passes, it would not impact Berkshire. Only in the unlikely event that Berkshire is found to be a threat to the system, the company would have to retroactively post collateral on contracts, which would require it to tie up capital. Inserting collateral requirements retroactively would be constitutionally dubious as it violates the sanctity of contracts, and would neither be fair nor smart, but the company can easily handle such requirement.

If Berkshire only has 230 derivatives contracts, and they are worth $63 billion — those are some, well, big contracts and represent a real concentration in Berkshire’s derivatives trading. Going by Schram’s note, ten years ago, the company had 23,000 contracts worth $5.4 billion, according to its 2000 annual report.

Last week, Sen. Ben Nelson (D-Neb.) came under fire for trying (and failing) to insert a provision into Sen. Blanche Lincoln’s (D-Ark.) derivatives proposal that would have ensured that the new rules do not apply to old contracts. Berkshire Hathaway will need to put up around $8 billion in cash (or possibly other very liquid collateral) to keep those $63 billion in derivatives contracts under Lincoln’s rules, now merged with Sen. Chris Dodd’s (D-Conn.) financial regulatory reform proposal.