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The big banks are going to be spending a lot of time in court.

Citigroup (C), Bank of America (BAC) and Wells Fargo (WFC) said in annual reports filed in recent days that they could face $6.7 billion in litigation-related losses in coming years beyond the amounts they have set aside in reserves. None of the banks foresaw any such losses in their filings last year.

Get used to it

The biggest potential hit is at Citi, which says its losses could hit $4 billion as it defends cases that take up five pages in its latest 10-K filing. These range from suits tied to the subprime mortgage mess to the Lehman Brothers bankruptcy to the underwriting of securities backed by U.S. home loans.

Bank of America said in its filing that its losses on legal cases could run $1.5 billion above funds it has reserved for the purpose. Thanks to its acquisition of Countrywide and Merrill Lynch during the financial meltdown, Bank of America has been spending considerable time and money dealing with cases tied to the housing bubble.

Wells Fargo says its losses could run as high as $1.2 billion. The other big banks may size up their legal exposures when they make annual filings in the next  day or two.

Also on Fortune.com:

• Are the public unions just scapegoats?
• Chicago’s new dean: resting on his laurels?
• JPMorgan’s $400 million tweet

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A year after Berkshire Hathaway completed its biggest acquisition, CEO Warren Buffett is on the hunt again.

Buffett told Berkshire (BRKA) shareholders in his annual letter to them Saturday that they should brace for more megadeals along the lines of last February’s $26 billion buy of railroad Burlington Northern Santa Fe.

Sure shot?

“Our elephant gun has been reloaded, and my trigger finger is itchy,” Buffett said.

Buffett may not strike you as much of a hunter. In the public’s mind, Buffett is a gatherer of blue-chip stocks such as Coca-Cola (KO) that he buys on the cheap and holds forever. His success in that endeavor has been immeasurably aided by his access to cheap funding via the insurance companies that Berkshire runs.

But while the insurance-funded investment business still accounts for much of Berkshire’s value, the future  lies elsewhere. More and more of Berkshire’s gains come from a growing stable of 68 non-insurance companies, ranging from giant Burlington Northern to niche operators like Business Wire and See’s Candies.

“For the past 10 years we have seen a clear strategic shift toward buying wholly owned businesses over publicly traded stocks,” said Whitney Tilson, a Berkshire shareholder and value investor who runs the $23 million Tilson Focus fund.

Why? Size is one factor. As Buffett has often lamented, the bigger Berkshire gets the more difficult it becomes to move the needle with a winning investment. The scale of the firm’s $158 billion investing portfolio “is absolutely an anchor on performance,” says Tilson.

For now, the value of that portfolio dwarfs the flows coming from the operating businesses. The investments were worth $94,730 a share at the end of 2010, Saturday’s letter says. Per-share pretax earnings at Berkshire’s noninsurance companies were worth $5,903 per share.

But the operating-company earnings stream is plenty valuable in its own right – a point Tilson makes in a slide show on his web site.

Even at a conservative multiple of, say, 7 times earnings, Berkshire’s operating businesses alone are worth $42 billion before taxes. That exceeds the market value of warehouse retailer (and Berkshire holding) Costco (COST), for instance, though the numbers aren’t strictly comparable because of the tax treatments.

Moreover, the earnings stream expanded at a 20% annual clip over the past decade – compared with a just 6.6% yearly increase in the value of the investment portfolio.

The earnings expansion stands to pick up in coming years if Berkshire succeeds in finding more big deals. The motivation is clear.

Consider the Burlington Northern purchase, which was half again as big as the previous biggest Berkshire acquisition, the 1999 purchase of insurer General Re. Buffett said in last year’s letter that the decision to make the cash-and-stock deal was “a close one,” because he doesn’t like issuing Berkshire stock.

But he said in Saturday’s letter that the railroad is “working out even better than I expected,” boosting Berkshire’s after-tax earnings capacity by more than 30%. Thanks in part to the strong flow of Burlington Northern earnings, Berkshire now can expect to generate around $12 billion in profits in a typical year, Buffett says.

That number may take a hit this year and next as some of the sweet deals Berkshire negotiated during the financial crisis – including a $5 billion investment in Goldman Sachs (GS) and a $3 billion purchase of General Electric (GE) preferred stock — run off.

But losing a few hundred million in dividends here and there hardly slows the torrent of cash that comes pouring into Berkshire every day. Buffett said in last year’s letter that he liked Burlington Northern in part because it gave Berkshire a way to put $22 billion to work in one shot.

Now, just a year after it swallowed the railroad, Berkshire is back to $38 billion in cash and cash equivalents.

With Buffett having sworn off dividends and stock repurchases, that money has to go somewhere. So which elephants might Buffett be after?

Tilson, for one, puts long odds on another megadeal. He notes that Berkshire already owned nearly a third of Burlington Northern before saying in late 2009 it would acquire the rest.

He views serial purchases of somewhat smaller, closely held businesses – along the lines of Berkshire’s 2006 purchase of the Israeli metalworking company Iscar or the ongoing acquisition of the Pritzker family’s Marmon Group – as a better bet.

“I think Buffett would love to buy 10 more Iscars,” said Tilson. “I’m sure he would love to buy Mars at the right price,” he adds — though there’s no sign that sweet deal is likely to present itself any time soon.

So 2011 will find Buffett in his familiar posture of looking for an opening – whatever that takes the form of an elephant or something less grand. 

As Tilson says, “I don’t think he spends a lot of time thinking about how he has to have any particular deal. It’s much more opportunistic than that.”

Also on Fortune.com:

• Berkshire reports a runner-up year
• The Lou Simpson effect
• Berkshire cleans up on derivatives bet
• The Buffett succession horse race

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

Filed under: Street Sweep

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Warren Buffett’s latest letter to shareholders won’t make it any easier to handicap the race to succeed the Berkshire Hathaway chief.

The letter, released Saturday, is full of praise for David Sokol (right). The 53-year-old has been with Berkshire (BRKA) for more than a decade and is widely cast as a leading candidate to take over as CEO when Buffett, 80, eventually steps aside.

Air apparent?

But Buffett also stresses the importance of youth, a factor that may not favor Sokol.

In a section of the letter discussing the recent hiring of investment manager Todd Combs, Buffett cites a preference for youthful promise over name recognition and an established track record.

“Our goal was to find a 2-year-old Secretariat, not a 10-year-old Seabiscuit,” he writes of Combs’ hiring.

If that logic applies to the CEO search, it could favor Greg Abel (below, right). He has run Berkshire’s MidAmerican Energy since Sokol gave up the reins in 2008, and at 48 is the youngest name on the putative Berkshire short list.

Others widely mentioned in the race include Ajit Jain, 59, who has run Berkshire’s highly profitable reinsurance business for 25 years, and Matt Rose, 50, of Burlington Northern, the giant railroad that Berkshire took over last year.

Buffett praises both of them as well in the letter, noting the success of the Burlington merger and claiming that “even kryptonite bounces off” Jain. That is a quality that surely will come in handy in his super New York apartment.

But Buffett reserves his warmest words for Sokol, who wears many hats at Berkshire. He is chairman of MidAmerican, where he has spent two decades, and also serves as chairman of Berkshire’s roofing company, Johns Manville. On top of all that, Buffett asked him last year to turn around NetJets, the fractional jet ownership company whose losses prompted Buffett to tell shareholders he had “failed” them.

Sokol has since restored the company to profitability – leading Fortune last year to dub him Berkshire’s Mr. Fix-It. Buffett’s latest comments will do nothing to dim that halo.

“I can’t overstate the breadth and importance of Dave Sokol’s achievements at this company,” Buffett writes. He says Sokol “turned what was Berkshire’s only major business problem into a solidly profitable operation,” while maintaining NetJets’ crucial reputation for safety and service.

Beyond these clues, there is little discussion of the succession issue in the letter. Buffett does note that Berkshire has “multiple outstanding candidates immediately available for my CEO job,” but unhelpfully he doesn’t go on to name or rank them.

Aptly named

And as always, Buffett is in no rush to step down. Asked once whether he’d do anything to make the price of Berkshire’s Class A voting shares (lately $130,000) more affordable for individual investors, he proposed splitting his age instead.

Buffett has been slowly preparing to loosen his grip on his role as Berkshire’s chief investment officer — though the letter makes clear that even that transition will be quite gradual.

Combs has been touted, improbably enough, in some corners as being groomed to take over the giant investing portfolio from Buffett. But the letter indicates that Combs may well get some friendly competition in a process that is likely to take years, assuming Buffett retains his good health.

Buffett says Berkshire may over time bring on another investment manager or two “if we find the right individuals.” That’s in addition to Combs, who will start out managing $1 billion to $3 billion in securities – focusing at first on stocks, though he won’t be restricted to them.

That’s just a pittance in Berkshire terms: its stock holdings alone were worth more than $61 billion at year-end. The lion’s share of those funds will stay with Buffett, who clearly is not eager to let go of the investing duties, let alone the CEO reins.

“As long as I am CEO, I will continue to manage the great majority of Berkshire’s holdings, both bonds and equities,” Buffett says in the letter.

But Buffett is well aware that all of us face being led out to pasture eventually – which is perhaps the risk of colorfully comparing Combs to Secretariat.

“Whoops,” Buffett says, “that may not be the smartest metaphor for an 80-year-old CEO to use.”

Also on Fortune.com:

• Berkshire reports a runner-up year
• The Lou Simpson effect
• Derivatives bet pays off for Berkshire
• Buffett hunting for another megadeal

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

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Score one for Warren Buffett in his crusade against the financial world’s worship of mathematical mumbo jumbo.

One of Buffett’s most controversial bets — a bubble-era wager on the long-term value of stock market indexes, using tools he once scorned as “weapons of financial mass destruction” — started to pay off in the fourth quarter.

Ticking less loudly

Berkshire (BRKA) posted a $222 million gain after its trading counterparty asked to unwind eight derivatives contracts known as equity puts, according to Saturday’s annual letter to Berkshire shareholders.

The gain marks Berkshire’s first realized, cash-in-the-pocket profit on the puts since Buffett started writing them seven years ago — not counting the money Berkshire has made by holding the cash its trading partners anted up in the first place.

Buffett says Berkshire’s gain on the widely criticized trade shows the mathematical models used on Wall Street don’t work – a fact Berkshire intends to exploit in its derivatives dealings. The Black-Scholes standard for option pricing “produces wildly inappropriate values when applied to long-dated options,” Buffett writes in the letter.

Berkshire entered into the put contracts between 2004 and 2008. They came under fire from pundits after the post-Lehman Brothers financial collapse seemed to sharply raise the odds the contracts would prove costly to Berkshire.

The puts obliged Berkshire to pay its unnamed counterparty at the end of the contact period, in this case between 2021 and 2026, if certain equity indexes such as the S&P 500 declined over the course of the contract. In a worst case scenario, in which puts expired with the indexes at zero, Berkshire would have been obliged to pay its counterparties in this and similar contracts a total of $38 billion at expiration.

Of course, when Buffett wrote the puts the major stock indexes didn’t look all that likely to be lower in a decade or two, let alone go to zero. But the odds were looking distinctly less favorable for Berkshire around two years ago, when the S&P, for instance, traded as low as 666 — 58% below its 2007 peak.

But since then, U.S. stocks have posted their fastest double on record. With the economy growing again and every market commentator furiously beating the inflation drum, Berkshire’s unnamed counterparty apparently decided to cut its losses. It unwound its bet on falling stocks for the long term just three years after making it.

It is clear that Buffett views the results as a point in his favor in a long-running debate over the financial industry’s embrace of abstruse mathematical models. He has insisted he would continue to write derivatives contracts when it suits him in spite of the name-calling the practice inspired.

Buffett has said he would do so as long as he could see a good chance to make money on a given deal – and on the condition Berkshire gets paid upfront by its trading partner, eliminating any of the counterparty risk that nearly helped bring down the financial system in 2008.

“I believe each contract we own was mispriced at inception, sometimes dramatically so,” Buffett explained in his 2008 letter to Berkshire shareholders.

No small part of that mispricing, Buffett says, is driven by what he views as the false precision provided by models like Black-Scholes. It combines data including prices, contract duration, expected volatility, dividend and interest rates.

Buffett says academics, regulators and some market practitioners prize the formula — named after the economists Fischer Black and Myron Scholes, who popularized its use it in a 1973 paper — for its capacity to estimate a precise value for an option over a long span. That, alas, is a quality Buffett scoffs at.

Buffett says he cannot reliably come up with a pinpoint value for any given long-dated option, but adds that he would “rather be approximately right than precisely wrong.”

How wrong is Black-Scholes? So wrong that Buffett says he applies the formula in Berkshire’s financial filings only through gritted teeth. He notes that doing so is standard accounting and allows auditors to reconcile the company’s numbers with those of its trading partners.

But Buffett believes the Black-Scholes estimate of Berkshire’s liability on the equity put contracts, for instance, is vastly overstated. That number is $6.7 billion at Dec. 31 – down from $7.3 billion last year, when more contracts were outstanding, and $10 billion at the end of 2008, when stock markets were far lower.

But Buffett says that were stocks to flatline between now and 2026, when the last of the contracts expire, Berkshire would actually owe just $3.8 billion.

This is a rather large discrepancy. But rather than idly criticizing the financial industry’s options pricing methods, “we put our money where our mouth was by entering into our equity put contracts,” Buffett writes. “By doing so, we implicitly asserted that the Black-Scholes calculations used by our counterparties or their customers were faulty.”

In this case, Berkshire, which had received $647 million in premiums in writing the contracts, paid $425 million to unwind them, resulting in the latest-quarter gain. But Buffett notes he also got the free use of the premiums over the three years the contracts were in effect. Buffett views the use of such so-called float as one of the key benefits of the insurance business, because it allows him to invest policyholder funds for Berkshire’s benefit.

Closing out the eight equity puts leaves Berkshire with 39 remaining put contracts, with a notional liability (if the indexes go to zero at expiration) of $34 billion.

Buffett is hardly the only financial bigwig to take aim at Black Scholes. But some other critics have in a sense taken the other side of this trade, contending that if anything the formula underestimates the potential liability of long-dated options by failing to adequately account for so-called tail risk — the prospect that the markets will collapse under the weight of, say, a giant housing bubble.

Such a downturn would increase Berkshire’s liabilities by increasing the amount it stands to pay out on the put contracts. So there is the risk, however slight, that Buffett’s view understates the risk Berkshire is shouldering in the event of another unforeseen market meltdown.

“Black-Scholes has plenty of problems,” says Espen Robak of valuation adviser Pluris. “But there’s a powerful argument that the chance of extreme events is greater than people probably think, and now is sort of a strange time to be implicitly making the everything-will-be-OK argument.”

Also on Fortune.com:

• Berkshire reports a runner-up year
• The Lou Simpson effect
• The Berkshire CEO horse race
• Buffett hunting for another megadeal

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

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