Chairman's Letter

Writing Puts

Though the press spun the release of Berkshire's 2007 chairman's letter one way, generally a focus on the company's 18% drop in accounting income (a practically meaningless figure), hats off to. FT.com for its article "Buffett defends sovereign wealth funds".

The chairman's letter contains the usual Buffettisms: the aggressive expected-return assumptions used by corporate America in accounting for pension expenses; expensing of stock options; the slide of the dollar; unbelievable candor; the overview of what makes a great business.

Then there was the new stuff: the defence of sovereign wealth funds; his near-term profit outlook for insurance companies; and, what piqued my interest, his expansion into put writing on indices.


Buffett is no stranger to investments outside the realm of boring but good businesses. Those familiar with Berkshire's history know that. But put writing is a first, at least at this scale and with this much disclosure. I cite a paragraph from page 16.

"The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period."

$4.5 billion in option premiums is great "float" to have over the next 15-20 years. These are European options--only exercisable at maturity--and have a strike price at current index levels! This makes me wonder, who is the counterparty? These are fantastic terms for Berkshire as markets will almost certainly be higher 15-20 years from now.

The Oracle's decades of experience and connections are proving again to be a boon for shareholders. The option writing alone is worthy of a headline in the financial press; for now, it seems to appear only in the minds of astute readers and in the blogosphere.



Disclosure: none