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Berkshire Stands Its Ground

Brett Horn, CFA

Brett Horn: Hello, I'm Brett Horn, associate director of equity research, here at Morningstar. We've got Berkshire Hathaway's annual meeting coming up this weekend, and I wanted to bring in Bill Bergman, our analyst who covers Berkshire, to talk about it a little bit.

Bill Bergman: Hi, Brett.

Horn: Hi, how are you doing?

Bergman: OK.

Horn: I guess there's a few topics I want to cover, but just to start with one topic: derivatives. This is a topic that there's been a lot of clamor about over the last couple of years, throughout the financial crisis.

Bergman: Rightfully so.

Horn: [laughs] Maybe the first thing to start with, what a difference a year makes, right? Last year, Warren Buffett had sold some, fairly large market puts. There was a lot of cry that, hey, maybe he'd misjudged this time, and Berkshire was going to lose a lot of money on them. A year later, it's looking a lot better. What would you have to say about that?

Bergman: I think that those equity put options, as well as the credit derivatives that Berkshire entered into, were both representative of a broader philosophy at Berkshire Hathaway. Where you have an institution that has traditionally exercised underwriting discipline in two different ways. One of them, is they're very careful when pricing is soft.

But at the other hand, they're also very resolute, and they stick to their guns when they think things are underpriced as well. And Berkshire has stood its ground during the financial crisis, in ways that exhibited both its internal financial strength and also bore fruit for shareholders in the last year or so. And we're seeing the fruits of that now.

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Horn: And, obviously, there was a big news item today was some of these financial regulations that are out there, some of the thoughts about how derivatives needed to be traded going forward. There was news about that, about Buffett potentially even influencing that legislation. Could you give us a little background on that, and what you think that means for Berkshire?

Bergman: Sure. Today, actually things are in flux as we speak, but we've had some significant financial reform bills that have been introduced both in the House and the Senate. And today, it looks like there's been some progress on the extent to which Berkshire's derivatives positions may be forced to either post more collateral or, even potentially, be forced into centralized clearing arrangements--which would in turn diminish Berkshire's traditional ability to press itself, and its own credit quality, as part of its competitive advantage in the derivatives arena and reduce the relative competitive advantage that they have and force greater collateral costs on Berkshire's derivative positions. There may be a good public policy reason for doing this. We've had a financial crisis of super proportion here, and, at the same time, so people are concerned that the financial institutions, including Berkshire Hathaway, that are exposed to there derivative positions, may have to post more collateral, in order to keep the system, as a whole, more safe.

But for Berkshire Hathaway, they were taking from the positions at a time when everyone else was in trouble, and Berkshire was providing liquidity to their derivatives markets. And it's a sad state of affairs that our strongest financial institutions are being forced to pay a price for the weaknesses of the firms that got us in trouble in the first place. But that's the way things look to be going.

Horn: Now, it seems like a relatively obscure issue, posting collateral for derivative transactions, but this really seems to strike at the heart of why Buffett gets into these. His kind of operating mantra is always, float is always great. So he always goes into derivatives.

...When you talk about the market puts, these are options, that by selling them, he gets money today, and has to potentially pay out down the line. Those seem to be very much the transactions that he prefers. This [legislation] would seem to, if the past... would seem to really mute operating strategy.

Bergman: That's the way it looks. And it's consistent, in turn, with our appreciation for float in the insurance business. Where the insurance premiums are received up front, and Berkshire pays out over time, invests in the interim, and hopefully underwrites well, and also makes money for shareholders on the investment side. Which is something, historically, that they've done in spades.

Now, there's a consistent philosophy there, with their equity put options, as well as their credit derivatives contracts, that has proved very beneficial for Berkshire shareholders in the last year. And consistent with their general underwriting philosophy in insurance. But it looks like public policy may be muting those benefits in the years ahead.

Horn: Well, thanks, Bill, I appreciate you taking the time to come and speak with me.

Bergman: Good. Nice to be here.

Horn: For Morningstar, I'm Brett Horn. Thank you for joining us.