Warren's well-paying weapon

NEW YORK (Fortune) -- Leave it to Warren Buffett to find a way to make millions - perhaps billions - of dollars in profits by selling the instruments he once termed "financial weapons of mass destruction."

Buffett, chairman of Omaha-based Berkshire Hathaway (BRKA, Fortune 500), famously used the company's 2002 annual report to deride financial derivatives - contracts that guarantee the buyer or seller a certain payment in the event of a gain or loss. Unlike insurance contracts, derivatives transactions are generally unregulated.

Buffett has criticized the way derivatives allow companies and financial institutions to increase their leverage, or use of borrowed money, out of the sight of regulators. He also noted that in many cases participants in derivative contracts hold little or no collateral, creating so-called counterparty risk - the prospect that a participant won't be able to collect on a claim. Buffett has warned that these factors, along with unclear disclosure, could expose investors to hefty and unforeseen losses. "The derivatives business continues to expand unchecked," he wrote in Berkshire's 2002 report. "Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts."

But Buffett's concerns about possible risks haven't kept him out of the derivatives business. Buffett wrote in Berkshire's 2007 annual report, published Friday on the company's Web site at berkshirehathway.com, that Berkshire has taken in $7.7 billion in premiums on 94 derivatives contracts it has entered into.

Buffett says Berkshire has taken in $3.2 billion in premiums on 54 derivative contracts that require the firm to pay up if certain bonds in various high-yield indexes default. Buffett said these swaps expire between 2009 and 2013, and could expose Berkshire to losses as large as $4.7 billion. But he calls that a worst-case scenario that is "extremely unlikely to occur" and notes that as of Dec. 31, Berkshire had paid out just $472 million on those contracts.

Berkshire's other derivatives exposure comes from its sale of so-called put options, which give the buyer the right (though not the obligation) to sell a financial instrument to Berkshire at a certain date. Buffett says the company has sold 15- or 20-year put options on the S&P 500 and three foreign indexes. The puts are exercisable only at their expiration, which is between 2019 and 2027. The options were struck at the market price on the day they were written, which is to say Berkshire is betting that stock prices will rise over the next decade or two. On these derivatives Berkshire has taken in $4.5 billion in premiums and has recorded a year-end liability of $4.6 billion.

Berkshire's position is noteworthy because fears about derivatives risks have reasserted themselves lately on Wall Street. Factors such as changing spreads between corporate and government bonds can slash the value of derivatives holdings, as investors in AIG (AIG, Fortune 500) learned this week when the insurer took an $11 billion mark-to-market writedown of its derivatives portfolio. And with stock markets increasingly volatile, investors have grown concerned that hedge funds and other sellers of derivatives will take losses that will prevent them from making good on their obligations. This worry has arisen most notably in the market for so-called credit default swaps, where a counterparty failure could leave the buyer bearing the full burden of a loss it had viewed as hedged.

Buffett assures investors that Berkshire is well aware of these issues. "In all cases we hold the money," he writes, "which means that we have no counterparty risk."

He adds that while changes in market conditions can cause large quarter-to-quarter swings in reported earnings - because accounting rules dictate that the fair value of derivatives be reflected in quarterly profit statements - he isn't concerned. Referring to Berkshire Vice Chairman Charlie Munger, Buffett writes, "He and I will not be bothered by these swings - even though they could easily amount to $1 billion or more in a quarter - and we hope you won't be either."

With Berkshire showing 21% annual growth in per-share book value over his 44-year career, Buffett may be the one executive who can reasonably persuade investors not to worry about a billion-dollar swing on the bottom line.

(A member of FORTUNE's staff, senior editor at large Carol Loomis, edits the chairman's letter in Berkshire's annual report.)