Kass: Buffett Gets a Free Pass

This blog post originally appeared on RealMoney Silver on May 5 at 7:41 a.m. EDT.

I view derivatives as time bombs, both for the parties that deal in them and the economic system.

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multimillion-dollar bonus or the CEO who wanted to report impressive 'earnings' (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade and eliminate bumps for individual participants. On a micro level, what they say is often true. I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

-- Warren Buffett's Letter to Investors, Berkshire Hathaway 2002 Annual Report

I have worshiped at the altar of Warren Buffett since the late 1970s. As the greatest investor of all time, what is not to admire?

That said, I am short Berkshire Hathaway (BRK.A Quote) based on what I consider to be a number of sound reasons, preferring to separate my admiration for Buffett from my analysis of Berkshire Hathaway.

Today, we will focus on several items:

• Berkshire's large first-quarter 2008 derivative losses;
• Berkshire's first-quarter earnings "miss"; and
• the Wrigley (WWY Quote)/Mars transaction.

All of which suggest that investors and Corporate America (in general) and the media (in particular) are giving Buffett a free pass. And that free pass has, in the past, inured to the benefit of the shareholders of Berkshire Hathaway -- though I am uncertain how long the benefits will continue.

Buffett's Berkshire Hathaway aggressively traffics in derivatives -- the very instruments of which he has consistently been critical. Back in February, Buffett revealed that Berkshire ended last year with about $40 billion of exposure on about 95 different derivative contracts.

After the close on Friday, Berkshire Hathaway reported that first-quarter 2008 results dropped by nearly two-thirds, as derivative contracts cost the company approximately $1.6 billion:

• $1.2 billion of the loss represented an unrealized loss on put options that the company wrote on the S&P 500 and three foreign stock indices; and
• $490 million came from unrealized losses on contracts insuring against defaults on high-yield bonds.

Not to worry, stated Buffett, as, in the fullness of time, he is confident that the contracts will be profitable -- though the variability of results will affect the company on a quarterly basis. Moreover, during Buffett's Woodstock for Capitalism, The Oracle of Omaha told over 30,000 shareholders that the executives at firms that were badly hurt by their investment in mortgage-complex-related derivatives "really didn't have any idea what risks they were involved with." In other words, he understands the risks of derivatives, while most others do not.