Buffett’s view on derivatives

Yesterday I wrote a missive about the current credit crisis and why I was confident that it would end badly using the Penn Square/Continental Illinois bank failures as a history lesson. The derivatives, CDOs, and Asset Backed Commercial Paper Programs are so complicated and illiquid that determining price has been a problem. Beyond what is the proper balance sheet treatment, the imperative question is can I sell the security at anywhere near par?

Warren Buffett’s experience with General Re’s derivatives portfolio gives us a clue to the magnitude and difficulty of the problem. Keep in mind that those derivatives were an early vintage portfolio, Berkshire’s General Re had the luxury of time that capital provides, and the Oracle of Omaha was assisting in the winding down. Many of today’s financial institutions won’t be as fortunate as Buffett.

From page 14 of Berkshire’s 2006 Annual Report: “You will be happy to hear—and I’m even happier—that this will be my last discussion of the losses at General Re’s derivative operation. When we started to wind this business down early in 2002, we had 23,218 contracts outstanding. Now we have 197. Our cumulative pre-tax loss from this operation totals $409 million, but only $5 million occurred in 2006. Charlie says that if we had properly classified the $409 million on our 2001 balance sheet, it would have been labeled “Good Until Reached For.”

“Good Until Reached For” is what the world’s financial institutions are struggling with today. Who is going to absorb the losses and what will be the unintended consequences? Right now, the banks don’t know, the regulators don’t know, CNBC and the media doesn’t know so stay far, far away from financials and don’t buy the financials on the dips.