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How Buffett used 'financial weapons of mass destruction' to make billions of dollars

·Lawrence Lewitinn

Warren Buffett once called derivatives “financial weapons of mass destruction.” But he is also open about using them on a large scale, and he’s made billions of dollars doing so.

“In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal,” wrote Buffett in Berkshire Hathaway’s (BRK-A, BRK-B) 2002 annual letter.

That statement has been cited often, but Russell Rhoads, director of program development for the CBOE’s Options Institute, maintains it was taken out of context.

“He was discussing the acquisition of General Re that Berkshire Hathaway had entered into,” said Rhoads. “They had inherited a book of over-the-counter derivatives and he was expressing his frustration with trying to figure out what they were worth, counterparty risk, and some other things.”

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Rhoads points out that in the page before calling derivatives “weapons of mass destruction” in the annual letter, Buffett notes that Berkshire Hathaway uses derivatives to execute some investment strategies.

One of those strategies is a huge bullish bet on global markets taken before the financial crisis. Between 2004 and 2007, he sold a total of $4.5 billion worth of put options on the S&P 500 (^GSPC), Britain's FTSE 100 (^FTSE), the EuroStoxx 50 (^STOXX50E), and Japan's Nikkei 225 (^N225) indices. He sold an additional $400 million worth of puts in 2008, putting the total premium received at $4.9 billion.

Puts give owners downside protection with the right to sell an index at a specific price on a given date. The puts’ values rise as the price of the indices fall. By selling those puts, Buffett was essentially taking a bullish position on the world’s largest markets.

During the financial crisis, the puts’ value shot up above the $10 billion mark, according to Berkshire Hathaway data. They have since fallen well below the $4.9 billion in premiums Buffett took in a decade or so ago.

“The intrinsic value now is down to just over a billion dollars, so they've done fairly well with these options contracts,” said Rhoads.

While the options were purchased more than 10 years ago, they don’t expire until between 2019 and 2027. That works to Buffett’s favor because one of the key factors in an options value is time; the more time until they expire, the more value the options have. While these options are still a few years away from expiring, a lot more time has passed since Buffett sold them so their time values have diminished significantly.

“They benefited more from the passage of time than more price appreciation because some of the indexes that they sold these puts on are actually at lower levels than when he sold these puts before the great financial crisis,” Rhoads said. “They've done well as the market continues to move higher. I think they'll continue to do well.”

Buffett is the only one able to take on such a large, long-term bet, particularly one involving shorting options, Rhoads added. “One of the things to get a counterparty to enter into a trade with you like that, you actually have to have a pretty sound credit quality,” he said. “We all think of conservative and high credit when we hear the words Berkshire Hathaway so I don't think that was an issue with the counterparties.”


Yahoo Finance will livestream the Berkshire Hathaway annual meeting on Saturday, April 30. For more, click here.