Buffett Loses a Billion Dollars

Shareholders of Berkshire Hathaway (BRKA) got their “fix” this weekend as the Oracle of Omaha held center stage at the company’s annual meeting. One of the more interesting topics NOT covered much by the financial press, was how Berkshire managed to post a $1 billion first quarter investment loss!

In fact, during the run-up to this past weekend’s “Woodstock of capitalism,” I didn’t hear much on CNBC about Berkshire Hathaway’s report Friday that first quarter profits plunged 64% from a year ago

It’s not that people aren’t saving a lot of money anymore by switching to Geico.

In fact, Berkshire’s insurance operation are performing very well, thank you. Buffett’s entire shortfall came not from Berkshire’s operating businesses. The loss came from the investment side of the company, specifically from derivatives contracts.

Financial Weapons of Mass Destruction, Hard to Value in a Credit Crunch

That’s perhaps surprising that Buffett, known for his legendary value investing acumen, could lose a billion on investments.

No, Warren Buffett hasn’t lost his touch either. In fact, Berkshire’s quarterly shortfall shows the one of the pitfalls to investing these days amid the credit crunch, and complying with new accounting rules that can lead to wide valuation swings.

It is perhaps ironic that Berkshire would report a rare quarterly loss as a result of derivates, which Buffett himself has called “financial weapons of mass destruction.” But these losses can befall any financial firm, and they’re becoming much more frequent than ever before.

Berkshire booked a loss of nearly $500 billion on credit default swaps intended to protect against junk bond defaults. The larger share of the hit, at $1.2 billion was recorded for unrealized losses on long term put option contracts Berkshire wrote on the S&P 500, and other stock indexes.

This is a stark illustration of the unpredictability that’s created by new mark-to-market accounting rules. Berkshire’s loss is due to the fact that these derivatives contracts have temporarily moved against Buffett. Rather than ignoring the impact until sold, the new accounting rule compels firms like Berkshire to mark down the current value of these derivatives to reflect today’s market value instead of “cost.”

Mark to Market is Mostly a Good Thing, But Can Lead to Wide Valuation Swings... Just Ask Warren

In explaining this loss Buffett said that he’s not “bothered by these swings even though they could easily amount to $1bn or more in a quarter”.

Many other companies, particularly in the financial sector, have blamed larger than expected losses on the new mark-to-market rules. In fact, this accounting practice also had a hand in General Electric’s (GE) surprising first quarter earnings miss – all of which came from GE’s large financial services business.

Mark to market accounting is generally a good policy for creating more transparency in the financial sector. At the end of each quarter, four times every year, investors get to see exactly what a firm’s various investment contracts are worth... at fair market prices.

Mark-To-Market Can Lead to Negative Accounting Distortions

In an era of “creative” financial products that are very difficult to even understand, much less value, mark-to-market accounting can negatively distort a company’s financial position too. Such was the case with Berkshire’s nearly $1 billion net loss from investments last quarter.

During a credit crunch, financial markets are essentially grid-locked with sharp slowdowns in trading for many securities. Trying to mark-to-market these already illiquid securities can result in assigning a price that’s anything but “fair.”

Fire-sale prices might be a more accurate description. In many cases the unrealized losses that result are much worse than would be necessary in a normally functioning credit market.

Investor’s should keep this potential negative accounting aberration in mind whenever valuing a financial stock. Judging from the turnout of adoring fans at last weekend’s annual meeting, Berkshire Hathaway’s shareholders seem unfazed by Buffett’s billion dollar loss.