REUTERS: Buffett's Berkshire: Volatility more than expected

By Jonathan Stempel and Lilla Zuill

NEW YORK (Reuters) - Warren Buffett's Berkshire Hathaway Inc underestimated the risks of falling stock prices to its billions of dollars of derivatives bets, yet still believes it is valuing the contracts fairly.

Berkshire laid out its assessment in a June 26 letter to the U.S. Securities and Exchange Commission, discussing derivatives contracts tied to where the Standard & Poor's 500, Britain's FTSE 100, Japan's Nikkei 225 and Europe's Dow Jones Euro Stoxx 50 trade in the future.

"We recognize that the index values of the four indexes declined between 30 percent and 45 percent at December 31, 2008 as compared to the prior year end index values," Chief Financial Officer Marc Hamburg wrote.

"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," he added.

The contracts expire between 2018 and 2028, Berkshire said last week.

Berkshire's letter was one of several pieces of correspondence with the SEC made public on Thursday about the company's annual report, which was released in late February.

According to the correspondence, Berkshire also agreed to SEC demands for more explanation on $1.8 billion of write-downs

on stock investments, and $2.7 billion of auction-rate and other municipal debt holdings. On June 29, the SEC said it completed its review without further comment.

The correspondence shows Omaha, Nebraska-based Berkshire, which has close to 80 businesses and ended June with more than $136 billion of stocks, bonds and cash, is struggling to comply with SEC requirements to disclose enough about its finances.

This issue had surfaced in June 2008, when the regulator demanded "a more robust disclosure" of how the insurance and investment company values its derivatives. Buffett did provide some additional disclosure, in what he called "excruciating detail," in his annual shareholder letter in February.

The derivatives contracts are a big reason Berkshire's earnings fell for six straight quarters. That string ended in the April-to-June period as stocks rebounded.

Berkshire still had $8.23 billion of paper losses and $37.48 billion of potential liabilities on the contracts at the end of June.

Buffett has often said he expects the contracts to be profitable. He also can invest the upfront premiums on the contracts as he wishes.

This is one reason the world's second-richest person believes the contracts are unlike derivatives that are "financial weapons of mass destruction."

The $1.8 billion of "other-than-temporary impair losses" in 2008 related mainly to 12 equity securities that "generally" lost 40 percent to 90 percent of what Berkshire had paid for them, Hamburg wrote on May 22. Berkshire did not write down six other securities that fell 20 percent to 40 percent, he said.

Hamburg also wrote that Berkshire had reduced its stake in auction-rate and similar municipal debt to $2.7 billion at year end from $6.5 billion six months earlier, but that the credit crisis slowed the runoff in the fourth quarter.

The auction-rate market seized up in February 2008 and has not recovered. Berkshire has said it does not plan to sell its auction-rate holdings at below face value and can hold them until they are auctioned off or redeemed.

Berkshire Class A shares closed Thursday up $1,150, or 1.1 percent, at $102,150 on the New York Stock Exchange.

(Reporting by Jonathan Stempel and Lilla Zuill; editing by Andre Grenon)

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