Warren Buffett’s annual letter to Berkshire Hathaway (BRK.A) shareholders mixed the stark realities of a down market with a dash of pride that the company had thus far been weathering the downturn more solidly than many. At the same time, the company reported a massive decline in fourth-quarter profit – but a profit nonetheless.

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“Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead,” Buffett said in this letter, striking an optimistic tone.

But he also said that he and right-hand man Charlie Munger are “certain the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond.”

The year 2008 “was devastating as well for corporate and municipal bonds, real estate and commodities. By yearend, investors of all stripes were bloodied and confused, much as if they were small birds that had strayed into a badminton game,” the letter said.

Berkshire’s net income in the fourth quarter of 2008 was $117 million, down 96% from $2.9 billion in the same period the prior year.

Annual income declined to $4.99 billion in 2008 from $13.21 billion the prior year amid declines in the value of its stock holdings, as well as weak results from areas such as its insurance division.

About the government’s attempts to restore the economy through its bailouts and other economic-revival measures, Buffett cautioned that, “These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.”

But he defended the actions, saying, “Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic.”

Buffett admitted in the letter with characteristic frankness: “During 2008 I did some dumb things in investments.”

He was particularly self-critical about a purchase of ConocoPhillips (COP) shares while oil and gas prices were near their peak: “I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.”

Also, he said that during 2008 “I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes ‘unforced errors.’”

And then there was the praise, particularly for Berkshire’s insurance and utility groups for delivering “outstanding results in 2008.” In the utility space, Buffett noted that Berkshire aims to be the “buyer of choice,” taking a swipe at private-equity companies

Buffett also said he’s happy about Berkshire’s investments in fixed-income securities issued by Wrigley, Goldman Sachs (GS) and General Electric (GE).

Then, Buffett made some observations about the markets overall. He asserted, for instance, that “bubble” in U.S. Treasuries may be regarding in hindsight as “almost equally extraordinary” as the Internet bubble of the late 1990s or the housing bubble earlier this decade.

Buffett, as he has done numerous times of late, cautioned that “clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long,” saying “that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.”

And as he has done for years, Buffett attacked derivatives, saying they are “dangerous” and that he doesn’t even think it’s possible to regulate them adequately.

“Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose,” Buffett said. “I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them. When I read the pages of ‘disclosure’ in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don’t know what is going on in their portfolios (and then I reach for some aspirin).”

Buffett also noted that Berkshire endorses mark-to-market accounting, the practice of generally valuing company assets at the current market price. MTM has been much maligned in certain circles, but regulators have continued to stand behind it. 

He added, though, that “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 valued.”

“Even so, we will continue to use Black-Scholes when we are estimating our financial-statement liability for long-term equity puts,” Buffett said. “The formula represents conventional wisdom and any substitute that I might offer would engender extreme skepticism. That would be perfectly understandable: CEOs who have concocted their own valuations for esoteric financial instruments have seldom erred on the side of conservatism.”

Berkshire Hathaway’s annual meeting will be on May 2 in Omaha, Neb.