Berkshire Hathaway chairman Warren Buffett said in his annual letter to shareholders that he endorses mark-to-market accounting, even though it helped produce the worst financial results for his company in the 44 years he has been running it.
“We endorse mark-to-market accounting,” he said. “I will explan later, however, why I believe the Black-Scholes formula, even though it is the standard for establishing the dollar liability for options, produces strange results when the long-term variety are being used.”
The widely respected investor, known as the Oracle of Omaha, went on to defend his company’s use of derivative contracts. “By yearend we had received premiums of $3.4 billion on these contracts and paid losses of $542 million,” he wrote. “Using mark-to-market principles, we also set up a liability for future losses that at yearend totaled $3 billion. Thus we had to that point recorded a loss of about $100 million, derived from our $3.5 billion total in paid and estimated future losses minus the $3.4 billion of premiums we received. In our quarterly reports, however, the amount of gain or loss has swung wildly from a profit of $327 million in the second quarter of 2008 to a loss of $693 million in the fourth quarter of 2008.”
He went on to discuss the “strange results” derived from adhering to mark-to-market. “At the request of our customers, we write a few tax-exempt bond insurance contracts that are similar to those written at BHAC [Berkshire Hathaway Assurance Co.], but that are structured as derivatives. The only meaningful difference between the two contracts is that mark-to-market accounting is required for derivatives whereas standard accrual accounting is required at BHAC. But this difference can produce some strange results.
"The bonds covered – in effect, insured – by these derivatives are largely general obligations of states, and we feel good about them," Buffett added. "At yearend, however, mark-to-market accounting required us to record a loss of $631 million on these derivatives contracts. Had we instead insured the same bonds at the same price in BHAC, and used the accrual accounting required at insurance companies, we would have recorded a small profit for the year. The two methods by which we insure the bonds will eventually produce the same accounting result. In the short term, however, the variance in reported profits can be substantial.”
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