Warren Buffett is a critic of derivative securities. Soon after his company, Berkshire Hathaway, acquired General Reinsurance, he discovered a boatload of derivatives that took years to unwind and resulted in massive losses. That's what prompted him to label derivatives, "financial weapons of mass destruction."
So it's a bit of a surprise to see Berkshire report $2.44 billion worth of derivative-related losses (on a before-tax basis) for the third quarter. These derivatives are European style equity index put options. A European option is one that can be exercised only at maturity, but never before.
Berkshire received a premium for selling these options to investors. Buffett is making a bet that stock markets will rise over time. If he is right, Berkshire keeps the premiums. But if he is wrong and stock markets fall, the investors can force Berkshire to buy the indexes from them at higher prices.
The outcome will not be known until the actual expiration dates; however, Berkshire must mark the derivatives to market every quarter. This can introduce a tremendous amount of volatility to the company's earnings. The large derivatives-related losses in the third quarter were a direct result of falling stock prices.
The good news is that Berkshire's operating businesses are doing fine. If not for the derivatives, the company would have earned close to $4 billion last quarter. Instead, it earned just $2.3 billion or $1,380 per share. Still not too shabby.
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