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Warren Buffett, considered by many to be the world’s smartest investor, rarely if ever gives public advice; until now. He recently urged Americans to buy stocks. I do not however, recall him issuing us a sell call prior to the $8T, 40% loss of U.S. stock market capitalization. Why is Mr. Buffett now encouraging massive private purchases of equities (e.g. by shifting remaining and safe cash and Treasury holdings into stocks)?

Might he now be feeling a bit concerned that Bailout II could fail like Bailout I did (which is why he then said he invested in Goldman (NYSE:GS) and GE (NYSE:GE)) and that BRK.A may feel it in the balance sheet? The mother of all bailouts could perhaps begin by stoking public sentiment to launch a stock-buying spree. After all, George Bush, currently the ultimate insider, said the economy would be fine – eventually.

What of the principles of risk management and prudence – keeping cash aside in case stocks and risky bonds suffer more pain? But just how much more can and should investors, and pension plans, and school endowments, and retirees, and would-be retirees, stand to risk and lose? Where would this cash come from but guaranteed deposits, money market funds, mattresses and Treasuries?

Let us not overlook another small point: who would the sellers be and why would they not be taking Mr. Buffett’s advice and holding on for the great returns to come? After reaping these (paper) returns, how would investors know when to sell – since we missed Mr. Buffett’s call on that? Investors who held stocks from before the last recession through now have sizable losses net of dividends and taxes – while those who owned Treasuries made money over that now lost decade for American (and world) stocks. Advice givers and takers both need credible means of timing the round-trip.

Never mind also the likelihood that real estate values may fall 15-30% from here and devastate consumer and banking system net worth; that corporate and consumer, and shadow banking system, and derivatives, and municipal debts are just beginning to register what will surely be record default rates; that world governments are facing record deficits (and so eyeing tax hikes and eventually printing away liabilities); that consumption and capital investment are plunging and that so too must profits and stock valuations - worldwide – no, let’s all not miss spring by waiting for the robins.

Robins aren’t out as the dead of winter approaches – for good reason. Be out then and you’ll be pushing up the daisies of spring; not gathering them.

It is quite obvious that Mr. Buffett did not call this bottom and is fortunate for the time being that Bailout II (BII) is being coordinated on an unprecedented global scale with borrowed public money. He is banking big time on BII working; which it won’t for the same reasons that I said BI wouldn’t on this site: a) asset valuations not addressed; b) stimulating real economy not addressed; c) good new capital thrown after dead assets and bad banks instead of invested in growth-producing activity; and now because – recapping bad banks will only offset some more of their coming even worse losses and does not provide new sound lending opportunities which stimulating real growth would.

I have no intention to fully dissect the risks that Berkshire Hathaway may face due to certain liabilities that it has incurred; but merely to point out that it faces very significant risks in the current worsening economic environment; and that mitigating those risks benefits from both government bailouts and rising stock prices.

Turning again to BRK: Mr. Buffett has made two very large derivatives investments that in a worse case scenario could devastate BRK’s balance sheet. The first are obligations to make payments if certain high-yield (low quality) bonds default. This investment seems to have been made at a time when default premia where low (risks vastly understated by the credit market); and when Mr. Buffett and most economists did not seem to expect even a recession to occur – risk premia have since exploded and the liabilitu attached to those guarantees must have multiplied. The $3.2B in premia received through year-end 2007 may indicate in the range of $100B+ of insured high-yield debt (I haven’t investigated details and don’t intend to – my purpose is merely to point out the significant risks). Net of recovery loss rates in severe recessions run well over 20%.

Payouts occur between 2009-2013, which would be during the belly of at least the most severe recession since the Great Depression. Berkshire’s estimate of aggregate payouts of $5.2B may be as much as $15B+ short of actual payouts. Payouts would be offset by additional premium income to a degree, but less so by the recent likely losses on BRK’s investment of that premium income. Realized pre-tax net losses could run to $15B.

Second, BRK has written put options on certain world equity indices which pay out only at their expiration dates between 2019 and 2027. Premiums received appear to be about $4.5B and again, are invested; and as of Q1 2008, BRK had written more puts. As in the case of the default guarantees, these puts were written at about the peak of world equity markets which have since fallen in the 40% range. The notional value of the respective indices could be estimated in the $85B range resulting in a possible (unrealizable as of yet) paper net loss of about $30B – mitigated by the present value of expected possible index valuation growth until payout dates.

Note that in the last decade, stock investors lost money after dividends and taxes through the internet boom, its mild ensuing recession, 9-11, and one of the longest subsequent periods of rising corporate profits in history. We now face an economic and financial debacle that already can only be compared to the Great Depression in terms of % loss of US net worth including the $8T loss in equity value, the $4T loss in real estate value, and the trillions more loss of value in risky bonds whose yields have rocketed up. The point: it is rapidly becoming probable that even in a 10 or greater year time-frame, stock index values against which BRK has written puts may be well below the levels at which the puts were written.

How much would Berkshire have to pay a buyer now to sell those puts and bond guarantees and what effect would that have on its Q1 $84B net tangible assets and $31B in cash depleted by the GE and Goldman investments? What of the worsening operating prospects for its insurance business?

Would it not have been more consistent with Mr. Buffett’s philosophy to have written the puts now, with fear and blood in the streets, instead of at the markets’ peak? The timing of both the writing of the puts and the high-yield bond guarantees are very strikingly at odds with his recent NY Times op ed favoring stocks. Write puts when markets are hurting and guarantee risky bonds when earnings and cash flow stand to rise more than fall.

This is not to intimate that Mr. Buffett is acting out of selfish motives; but is intended to point out that huge downside risks remain in stocks, risky bonds and jobs that only those who can withstand a long, cold winter – and who believe a bottom may be near – should venture into buying more stocks, real estate and risky bonds.

Source: A Bailout for Berkshire?