Warren Buffett acknowledged on Saturday that his Berkshire Hathaway Inc will probably lose money on some of the derivatives contracts that have prompted some to speculate that the world's most famous investor has lost his touch.

At Berkshire's annual shareholder meeting, Buffett offered a gloomy forecast for parts of the U.S. economy and Berkshire itself, though he said massive federal efforts to stimulate activity could pay off at a possible cost of higher inflation.

It has been a very extraordinary year, Buffett said. When the American public pulls back the way they have, the government does need to step in.... It is the right thing to do, but it won't be a free ride.

The meeting attracted a record 35,000 people to the Qwest Center in downtown Omaha to see the world's second-richest person, often considered the world's greatest investor.

But it had a decidedly more serious and somber tone from years past as many investors expressed worries about the economy, Berkshire's investments, and how long the 78-year-old Buffett plans to stay on the job.

Half the questions were pre-screened by journalists, providing a tougher and more substantive dialogue with Buffett and his 85-year-old vice chairman, Charlie Munger.

Buffett said housing prices have yet to stabilize broadly, that retailers may be under pressure for a considerable period of time, and that he would not buy most U.S. newspaper companies at any price.

He also said that in insurance, which comprises about half of Berkshire's operations, the earnings power was not as good last year as normal and won't be as good this year.

Buffett also said the four candidates to replace him as Berkshire's chief investment officer failed to outperform the Standard & Poor's 500 last year, but remained confident they could perform well over time. Berkshire still has three internal candidates to replace Buffett as chief executive.

DERIVATIVES

Berkshire's stock has fallen 39 percent since December 2007, and profit last year fell 62 percent from a year earlier. Buffett said he would not buy back Berkshire stock now, because its share price is not demonstrably below the company's intrinsic value.

Buffett had transformed Berkshire since 1965 from a failing textile maker into a conglomerate with close to 80 businesses that sell such things as Geico car insurance, paint, ice cream, and underwear. It also has tens of billions of dollars of investments.

Much of the worry about Berkshire has focused on Buffett's use of derivatives in making long-term bets on the direction of stocks and junk bonds, and which have so far resulted in billions of dollars of paper losses.

While Buffett still expects the contracts tied to equity stock indexes to make money, he said we have run into far more bankruptcies in the last year than is normal. He said he now expects the contracts tied to credit defaults will show a loss before investment income, and perhaps after as well.

Buffett still distinguishes his derivatives from others such as credit default swaps, given that he collects billions of dollars of premiums upfront to invest and posts little collateral. He called other derivatives a danger to the system. There is no question about that.

The more serious mood extended to the traditional movie made by Buffett's daughter Susie, which dispensed with its usual humorous cartoon, though it showed Buffett attempting to teach Tiger Woods how to improve his golf game.

Berkshire's off year did not dissuade hundreds of shareholders from lining up outside ahead of the arena's 7 a.m. opening.

We'd rather be at the front of the line, said Linda Moore, a Brookfield, Michigan resident who said she lined up at 2:50 a.m. It's the best weekend of the year: informative, exciting, energetic.

CONFIDENCE IN BANKS

Buffett expressed confidence in Wells Fargo & Co, one of Berkshire's biggest investments, saying it has by far the best competitive position of any large U.S. bank.

He also said some banks will weather the credit crisis well, saying that if he wanted to turn Berkshire into a bank holding company, I would love to buy all of US Bancorp, or I would love to buy all of Wells.

He also defended Berkshire's roughly 20 percent stake in Moody's Corp, a credit rating agency faulted for failing to predict the housing crisis and assigning high ratings to risky debt for too long.

They made a huge mistake but were not alone, Buffett said. The rating agency business is probably still a good business, (but) it won't be doing the volume probably for a long time in certain areas of the capital markets.

Buffett declined to name the candidates to replace him as chief executive officer and chief investment officer, but said Ajit Jain, who runs much of his insurance businesses and whom investors believe is a CEO contender, is irreplaceable.

It would be impossible to replace Ajit, he said. We wouldn't give the latitude to size or risk that we would give to Ajit.... We won't find a substitute for him.

Buffett said that for any CEO candidate, the biggest job they have will be to develop relationships with potential sellers of businesses.

But he added that while Berkshire is much less nimble than it was when it was smaller, our sustainable competitive advantage is we have a culture and business model that people would find very, very difficult to copy.

Munger added: The stupidity in the management practices of the rest of the corporate world will likely be ample enough to give this company some comparative advantage in the future.

(Reporting by Jonathan Stempel and Lilla Zuill, editing by Vicki Allen)

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