Berkshire Hathaway defends derivative valuations

Warren Buffett's company is defending the assumptions it makes to estimate the value of its derivatives, even though they don't fully account for the broad market losses experienced in the last two years.

Berkshire Hathaway Inc. revealed additional details about how it values its derivatives and a couple of other investments in correspondence with regulators that was disclosed Thursday. The Omaha-based company was responding to questions from the Securities and Exchange Commission about its 2008 annual report.

Berkshire's chief financial officer, Marc Hamburg, said the company assumes an average 22 per cent volatility for its derivatives tied to four equity indexes. That's well short of the 30 to 45 per cent decline the four equity indexes experienced in 2008.

"Even though these short-term declines are in excess of our volatility inputs, we continue to believe that our volatility inputs are reasonable given the long-term nature of our equity index put option contracts," Hamburg said in one of the letters to the SEC.

The volatility figure Berkshire uses is based on the market circumstances when the contracts were written.

Berkshire spokeswoman Carrie Kizer said no one was immediately available Thursday to answer questions about the letters.

Berkshire officials have said they have no plans to sell the equity-based derivatives before they expire between 2019 and 2028.

The equity-based derivatives, along with Berkshire's other derivatives, generated a $1.5-billion gain in the company's second quarter nearly half the company's $3.3 billion quarterly profit as stock markets improved.

Buffett has predicted the contracts will ultimately be profitable because Berkshire is able to invest the premiums it received for them. The true value of the derivatives won't be clear for several years, but Berkshire has to estimate their value every quarter, which has made the company's quarterly earnings volatile.

During the first quarter, Berkshire's largely unrealized $986-million derivative losses contributed to the company's $1.5 billion loss, which was its first quarterly loss since 2001's third quarter, when the company suffered large insurance losses as a result of the Sept. 11 attacks.

Berkshire promised to expand what it discloses about its derivatives in future earnings reports. In February, Buffett also devoted nearly five pages of his annual letter to shareholders to explaining Berkshire's derivatives.

In the correspondence disclosed Thursday, Hamburg also provided the SEC with additional information about a $1.8-billion writedown in stock investments that Berkshire recorded in 2008.

Hamburg said the company decided to write down 12 stocks that were trading for 40 to 90 per cent less than Berkshire paid for them because Berkshire officials decided the prospects for those companies were uncertain.

Berkshire did not identify the stocks it wrote down, and Hamburg said Berkshire did not write down six other stocks that had lost 20 to 40 per cent of what the company paid because Berkshire officials believe those companies and their stock prices will rebound.

The SEC also asked about how Berkshire valued the $2.7 billion in auction-rate securities it held at the end of 2008.

Buffett's company has been selling off its auction-rate securities since mid-2008 when it held $6.5 billion worth. Berkshire says it doesn't plan to sell any of the securities for less than it paid for them, so it hasn't written down their value even though the market for auction-rate securities fell apart during the downturn in credit markets.

And Berkshire says all the auction-rate securities it holds were issued by companies with good credit, so officials are confident the securities will eventually be either sold or redeemed.

Berkshire owns a diverse mix of more than 60 companies, including insurance, furniture, carpet, jewelry, restaurants and utility businesses. And it has major investments in such companies as Wells Fargo & Co. and Coca-Cola Co.