Berkshire Valuation Questionable as Business Fails Guidance Tests

In an annual letter to shareholders in March 2003, Warren Buffett soundly condemned derivatives products as being "financial instruments of mass destruction"; however, since the release of its 2008 first quarter report, it is becoming apparent that the Berkshire Hathaway (BRK.A) business model was expanded to include credit default swaps, equity index options and foreign exchange contracts.

In its description of the risk on its derivatives business in the annual 2007 statements, referred to in the most-recent SEC filings, Berkshire disclosed a $16 billion year-on-year rise (to US$40 billion) in the "maximum exposure" of its derivatives contracts pertaining equity index and credit default coverage; the company received a total of $2.9 billion in premium payments for writing derivatives risk through the course of last year.

Berkshire began this year by recording an unrealized loss of $1.6 billion on its derivatives transactions (futures, options and swaps). That number now has risen to $2.2 billion, according to Berkshire's latest filings, after a $654 million improvement in the second quarter. Given that the size (notional value) of Berkshire's equity index put options is in excess of $37 billion, will Berkshire close the year with unrealized losses of $3.5 billion, or higher, depending upon the valuations derived from leading market indicators? If the answer is "yes", Berkshire shares can safely be considered overvalued at Friday's close, regardless of near-term fluctuations in the major equity indexes.

In its public disclosure, Berkshire has continued to maintain that, since its derivatives transactions are long-dated (20 years in some instances), the "amount of cash basis gains or losses will not be known for years." (2007 Annual Report) But that is exactly where the questions are grounded. What are the pillars on which the fair value measurement is currently being obtained, since Berkshire adopted the provisions of SFAS No. 157, on January 1, 2008? What is the maturity ladder for Berkshire's long-dated deals? And what implicit assumptions, including volatility assumptions, were made for the S&P 500, and other indexes, at the point of engagement and at the moment of valuation?

Naturally, Berkshire's derivatives will have an unprecedented influence on Berkshire's profitability through the course of 2009, and beyond. If the domestic and global recession proves to be deeper than earlier forecasted, revenues from Berkshire's non-derivatives insurance and reinsurance classes will continue on a downward path, with no visible reversal window in the foreseeable future.

In his March 2003 letter to Berkshire's shareholders, Mr. Buffett said that many of the derivatives contracts were devised by "madmen". Quite clearly, some the madness filtered through to the Berkshire risk management book. For the market as a whole, and perhaps for the regulators, it will be interesting to analyze how Berkshire's accountants are signing off on fair value measurements in the absence any active markets for reference instruments or indexes, and without access to any credible models which can define the structure of a stock market 10 and 20 years into the future, at least for accounting purposes.

Or should an assessment of Berkshire's solvency ratios be predicated on the full notional value ($48 billion) of its open derivatives position, as part of a deliberate deleveraging process, prior to determining the company's shareholder value? For the record, Berkshire confirms in its filings that it has not posted any collateral on such open positions.

Speaking of shareholder value, how is Berkshire going to recognize (in the fourth quarter) the ability (or otherwise) of Goldman Sachs (GS) and General Electric (GE) to service the 10% interest factor on its perpetual preferred investments?

Disclosure: Short C and GE.

Comments

[investor88:]

Excellent article, the spirit of enquiry is alive and well. Rakesh is not daunted by the investment giant Warren Buffet who in effect says he can do no wrong. Warren may not be wrong, but some probing is in order by people like Rakesh who refuse to take things at face value.

2008 Nov 09 08:54 AM

[Swiss Investor:]

'If the answer is "yes", Berkshire shares can safely be considered overvalued at Friday's close, regardless of near-term fluctuations in the major equity indexes.'
How do you arrive at the enterprise valuation from a couple of derivative positions?

2008 Nov 09 11:31 AM

[DonSuper:]

this nonsense articles should not be allowed in SA, I am not even sure they belong in Yahoo MB...

A little honesty would at least require to say that Buffett said that he expected wild swings in this contracts, and that the reported earnings in any given quarter could be severely affected, but they should be profitable in the end (more than 10 years to go before money actually exchanges hands)...

2008 Nov 09 12:32 PM

[gokou3:]

Ahh... Rakesh you are not implying that BRK may lose the $48B notional value of these contracts are you? Let's see... BRK collected about $5B in premiums, and the durations of these contracts are 10+ years. Assuming 0% growth of this premium, the stock index would have to drop 10% cumulatively over the next 10 years before BRK would lose a cent. Of course you have to take the accounting roller coaster ride in the meantime, but from your post I think that's too much.

2008 Nov 09 01:36 PM

[mkreisel:]

Rakesh, if Berkshire has to recognize the full $48B of the notional value, it means you would have already been vaporized in the nuclear fire of World War III.

Do you understand what it means for the world if stock indexes all go to zero?

2008 Nov 09 10:27 PM

[djw:]

Value of Put Notional
portfolio Index level 20 day vol
December 31, 4,610 35,043 1468.36 17.97%
March 31, 6,171 40,088 1322.70 29.43%
June 30, 5,845 39,878 1280.00 20.60%
September 30, 6,725  37,042 1164.74 57.72%

There is something rotten in the state of Omaha - the numbers do note compute - just maybe they changed the vol to 18% as the long term rate
How can the Sept position be a lesser notional value than March given the market has fallen and vol doubled.

2008 Nov 09 11:58 PM