Buffett's huge derivatives bet proves costly

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Golden Age
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Buffett's huge derivatives bet proves costly

Shares of Warren Buffett's insurance holding company
are on the ropes this month, plunging 30% in part because the famed
investor dabbled in an area of the market he has long publicly derided:
derivatives. And due to a tangled web of financial relationships, they
may be taking Goldman Sachs shares down with them.

Investors
are concerned about a $37-billion bet that Buffett made last year that
U.S. and world equity values would be higher in 15 to 20 years than
they were then, when the Dow Jones Industrials were trading around
13,000. Through his firm, Berkshire Hathaway, Buffett sold option contracts, known as "naked puts" to an undisclosed group of investors for around $4.85 billion, reportedly using Goldman as broker.

The
buyers saw the puts as a type of insurance that would pay off royally
if stocks fell over the next decade. They were seen by Buffett as an
easy way to pocket a quick $4 billion-plus, which was booked much like
an insurance premium, even though he is famous for scoffing at
derivatives as "weapons of mass financial destruction."

But
easy money is the worst kind. The problem is that stocks worldwide have
gone downhill in a hurry, and with a lot of the sort of volatility that
makes put contracts swell in value. And due to accounting rules, this
has made Buffett already need to mark down a $6.7 billion loss on the
trade even though the trade has another 14 years to work out.

Because
of its solid-gold credit rating, Berkshire Hathaway was not required to
put up collateral to make this trade. But now rumors are flying on Wall
Street that the owners of the contracts have demanded that broker
Goldman Sachs put up collateral for the rest of the amount due. Since
the value of the trade could be enormous, the collateral demands are
said to be very large, and fears that Goldman will struggle to make
good on its obligation has panicked shareholders.

Indeed one theory making the rounds this week is that Buffett put $5 billion into Goldman at around $125 per share in September not as an investment but to help provide funds for the collateral. 

Of
course, there are other reasons for investors to sell Berkshire shares,
which are down 42% overall this year, back to 2003 levels. Many of its
biggest stock holdings have plunged in value this year, including American Express, General Electric, SunTrust and
Goldman itself. And like most insurance companies, it holds a lot of
bonds that have plunged in value during the credit debacle.

To see how Buffett described the put contracts in his 2008 letter to investors, click here. There's
little doubt that he and Berkshire will survive this mess. But for now
this a blemish on his otherwise sterling record of achievement.

http://blogs.moneycentral.msn.com/topstocks/archive/2008/11/20/buffett-s...

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