Warren Buffett has spent the last ten years or so lecturing everyone on the dangers of derivatives. One good aspect of the Dodd bill is a little sunshine has spread into the Berkshire empire. While Mr. Buffett rails against everyone else using, “financial weapons of mass destruction”, he is a very active user of the instruments.
Among the scads of businesses that Mr. Buffett owns, some are energy businesses. He owns natural gas pipelines, electric companies, and other power generating services. He manages the operating risk of running these companies by entering into OTC derivative contracts. Last year, Berkshire Hathaway generated $6.3 billion in upfront cash by entering into derivative contracts. Because BH operates from such a strong financial position, they don’t have to put up cash to hedge. If they hedged their energy risk on a clearing house, they would have to post margin. Buffett gets to use the $6.3 Billion and put it to work somewhere else.
Additionally, Berkshire Hathaway has insurance businesses, and credit card businesses. Almost certainly, they use OTC derivatives to hedge their credit exposure, interest rate exposure, and currency exposure. This generates more cash for them.
Mr. Buffett is engaging in a fight for his financial statements. If Senator Blanche Lincoln‘s OTC amendment were to go through, Buffett would lose financially on more than a few fronts. First, there would be a big hole in his Statement of Cash Flows under “sources for cash”. Losing over $6.3 Billion wouldn’t cripple him-but it makes life a little more challenging. There is an opportunity cost to that money. Secondly, OTC derivatives can be shown in notes to financial statements. They are off Balance Sheet items. This means you don’t have to explicitly account for them as assets or liabilities. Accounting for them would change the financial position of the company. Because the underlying markets fluctuate, the financial position of the company would fluctuate making it harder for bankers to evaluate the business. This makes it harder and more expensive to get loans-costing a company like Berkshire even more.
Recall, Berkshire ponied up around $10 billion in cash and received preferred shares in Goldman Sachs. If Goldman has to spin off it’s OTC trading arm, Goldman’s profitability would be hampered. Over 30% of the top line revenue at investment banks like Goldman are generated from proprietary trading activities. Berkshire’s investment in Goldman would be encumbered. It will take longer to pay off, and will tie up Berkshire cash longer than it normally would have. Impairment of Goldman will hurt Buffett.
This entire discussion ignores the massive tax effects changes in financial reporting would have on Berkshire. Accounting for OTC derivatives differently would have a big effect on the tax liability of the company in more ways than one. It would take one quite a while to sort through all the effects, but rest assured, the number is not small.
Mr. Buffett likes to talk in a “folksy” down home manner. He is whip smart, and understands marketing as well as he understands high finance. He has marketed himself, and Berkshire as just a little old company from Omaha, Nebraska. But these little rays of sunshine show that Mr. Buffett speaks with a forked tongue. He doesn’t want others to compete with him, and is not above using a little “crony capitalism” to help his business. Just like every other special interest group and lobbyist in Washington today.