Berkshire had 250 derivatives contracts with a notional value of $63 billion at the end of 2009. They include long-dated equity put options on equity indexes and high-yield bond indexes. The company also sold protection through credit derivatives on the debt of states, municipalities and individual companies.
Buffett famously called derivatives "weapons of mass destruction," so his foray into this market raised some eyebrows.
In 2008, when stock and credit markets plunged, Berkshire reported an accounting loss of $6.8 billion. However, the company recognized a $3.6 billion accounting gain when markets recovered in 2009. Buffett has advised shareholders to ignore those accounting-induced swings.
The contracts gave Berkshire $6.3 billion in cash up front.
That is money Buffett can put to work in other investments.
Crucially, Buffett also structured almost all the derivative contracts so that Berkshire doesn't have to post collateral if the positions move against the company over the short term. This type of collateral posting requirement felled American International Group Inc. in 2008, triggering a huge government bailout.
However, derivatives legislation being considered in Washington could force companies to set aside more collateral against derivatives contracts. If passed, this could force Berkshire to do the same on its existing contracts.
"If we were found to be dangerous to the financial system by the Treasury Department or some commission" Berkshire would be required to post collateral on its contracts, Buffett said Saturday, describing the potential effect of the legislation.
Buffett said that Berkshire shouldn't be considered a danger, noting that it has 250 derivative contracts while other firms have as many as a million contracts.
Still, Buffett said that if "sweeping" legislation passes, Berkshire would comply with it. However, he stressed that the company would expect to be compensated for re-writing its derivatives contracts.
"We would like that language to be in the bill," Buffett said.
Counterparties pay more for derivatives contracts that are backed by collateral and Berkshire probably missed out on roughly $1 billion of extra premiums by structuring its contracts without collateral posting requirements, he noted.
"One has to wonder to what extent Berkshire may be being penalized for the sins of others," Bill Bergman, an equity analyst at Morningstar, said in an interview before the annual meeting. "Public policy and the reaction to financial crises have costs by potentially rewarding weak players that were threatening the system and penalizing the strong."
Berkshire has become involved in the political process on the legislation. Sen. Ben Nelson (D., Neb.) opposed the part of the legislation that would apply retroactively to derivatives contracts that have already been written. Nelson has reportedly received tens of thousand of dollars in campaign contributions from Berkshire and owns millions of dollars in Berkshire stock.
Berkshire executive David Sokol, considered a candidate to replace Buffett, met with lawmakers on Capitol Hill to try to get the provision struck from the bill, The Wall Street Journal reported recently.