Berkshire Hathaway Credit Risk, Index Puts Are Overblown Worries 48 comments
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I’ve seen a lot of crazy things in my investment career, but I struggle to think of anything that tops this: Berkshire Hathaway’s (BRK.A) five-year credit-default swap spreads have more than tripled in the past two months and now stand at 475 basis points (CDS quotes in this article are as of the end of day 11/19/08 and stock quotes as of 11/20/08), as this chart indicates (click charts to enlarge):
To get some perspective on what this means, the median CDS spread for companies with the lowest investment grade bond rating (BBB-) is 348 basis points, according to Moody’s, so the CDS market is indicating that AAA-rated Berkshire is junk! Or consider this chart, which shows that Berkshire’s CDSs are higher than a wide range of other financial companies [more than 4x Travelers (TRV), 3x JP Morgan Chase (JPM) and well above Citigroup (C), even after Thursday’s stock collapse – the world has truly gone mad!]:
A final thought on how crazy Berkshire’s CDS spreads are: What are investors who are buying CDSs on Berkshire thinking regarding counterparty risk? If things get so bad that AAA-rated Berkshire Hathaway goes bankrupt and defaults on its debt, what counterparty is likely to still be standing to pay on the CDSs???
Investors appear to be spooked by the widening CDS spreads, causing the stock to tumble to a low today of $74,100, down 37% in the past two weeks to its lowest level in more than five years. Berkshire is among our largest positions, so the decline has been painful, but we’re delighted to have the opportunity to add to our largest investment at such attractive prices, and have been doing so aggressively.
Beyond the ever-present worries about Buffett’s age (he gets one day older every day – SURPRISE!) and the dreadful economy, the market’s recent concerns appear to revolve around the Q3 earnings report, which was released on November 7 (the stock has declined every day since then), and derivative contracts that Buffett wrote mostly last year. Let’s address them in order:
The headline was that Berkshire’s net earnings fell 77% in Q3, but this was mostly due to $1.3 billion on noncash “losses” on derivative contracts (discussed further below). Berkshire’s after-tax operating earnings declined 19.2% year-over-year during the quarter, but were still a remarkable $2.1 billion, a respectable performance in light of the weak economy and two major hurricanes, Gustav and Ike, which led Berkshire to book significant super cat losses that reduced insurance underwriting profits from $486 million in Q3 07 to $81 million in Q3 08. Berkshire’s non-insurance businesses had operating earnings of $1.18 billion, up 2.3% (that’s not a typo), thanks in part to the Marmon acquisition.
In summary, Berkshire’s operating businesses are weathering the downturn well, remain enormously profitable and generate huge amounts of cash. In addition, thanks to committing more than $50 billion to new investments this year, money that had previously been in cash and low-yielding bonds, Berkshire’s cash generating power will increase substantially in the future.
If one does no analysis, Berkshire’s derivative contracts appear to pose similar risks to those that caused AIG and others to collapse, but in reality, nothing could be further from the truth.
There is no mystery about these contracts (or at least there shouldn’t be), as Buffett has provided a great deal of disclosure. Here is the relevant excerpt from his 2007 annual letter (www.berkshirehathaway.com/letters/2007ltr.pdf, page 16):
Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories.
First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.
We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in “Derivative Contract Liabilities” on our balance sheet.
The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.
Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.
Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.
Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.
During the first nine months, Berkshire’s derivatives had an unrealized pre-tax loss of $2.21 billion. However, that is a figure incorporating gains and losses in several different kinds of derivatives. Fundamentally, the size of that figure reflects the fact that we recorded a $2.06 billion unrealized loss in our two major categories of derivatives. This represents an increase in our loss during the third quarter of $1.05 billion from the loss of $1.01 billion we recorded during the first six months.
At the end of the third quarter, we had a liability of $6.72 billion for equity index put option contracts for which we have received cash payments of $4.85 billion. This means our recorded loss to date is $1.87 billion though the first payment that could be triggered would be in 2019, and the average maturity is 13.5 years. In the meantime all of the $4.85 billion can be invested by Berkshire.
Finally, here is the table on Berkshire derivative contracts from the Q3 10-Q:
Note 5. Derivative contracts of finance and financial products businesses
Berkshire utilizes derivative contracts in order to manage certain economic business risks as well as to assume specified amounts of market risk from others. The contracts summarized in the following table, with limited exceptions, are not designated as hedges for financial reporting purposes. Changes in the fair values of derivative assets and derivative liabilities that do not qualify as hedges are reported in the Consolidated Statements of Earnings as derivative gains/losses. Master netting agreements are utilized to manage counterparty credit risk, where gains and losses are netted across other contracts with that counterparty.
Under certain circumstances, including a downgrade of its credit rating below specified levels, Berkshire may be required to post collateral against derivative contract liabilities. However, Berkshire is not required to post collateral with respect to most of its credit default and equity index put option contracts and at September 30, 2008 and December 31, 2007, Berkshire had posted no collateral with counterparties as security on these contracts.
A summary of the fair value and gross notional value of open derivative contracts of finance and financial products businesses follows. Amounts are in millions.
So what does all of this mean? Simply put, Buffett has sold long-dated insurance against the debt of specific companies (credit default obligations or CDSs, expiring between 2009 and 2013) and against declines in the world’s major stock market indices (equity index put options, with the first expiration in 2019 and average maturity of 13.5 years).
When evaluating these investments, there are two considerations: will they ultimately be profitable (which won’t be known for another 19 years in some cases) and are there triggers that could cause a short-term liquidity crunch for Berkshire? In short, we believe the answers are almost certainly yes and absolutely not, respectively.
Since Buffett wrote these contracts, CDS spreads have widened and the world’s major stock market indices have fallen precipitously, such that Berkshire booked unrealized pretax losses of $2.2 billion in the first three quarters of this year. Given what the markets have done since September 30th, there could be an additional $1-2 billion in mark-to-market, noncash losses so far this quarter.
Were the CDS Contracts Good Investments?
Regarding the CDS contracts, we don’t know which companies Buffett wrote CDSs on, nor what he was paid, but it doesn’t appear that the counterparties can exercise the CDSs and demand cash based on current prices – rather, Berkshire has to pay only in the event of an actual default. Here’s the relevant excerpt from Buffett’s 2007 annual letter:
…we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.
We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold.
So far this year, Buffett has written more of these contracts, bringing the notional value (i.e., maximum loss) from $4.7 billion to $10.8 billion (as of the end of Q3, according to the table from the 10-Q, above).
If these contracts were written by anyone else, I would be worried about substantial losses over the next few years, but given what I know about Buffett, I think it’s likely that this will prove to be a profitable investment.
Were the Equity Index Put Option Contracts Good Investments?
But what about the much larger equity index put option contracts, for which Berkshire was paid $4.85 billion and had suffered noncash “losses” of $1.9 billion through Q3? Surely this was a huge mistake, right? Again, not so fast…
Buffett sold at-the-money puts on the four major world market indices at various times over the past few years – we don’t know at what level, but let’s assume the worst cases that these indices are down by 40% on average from their strike prices. If the indices rebound by 67% over the next 13.5 years (the average remaining duration of the puts), a mere 3.9% annually, then the puts will expire worthless and Buffett can pocket the entire $4.85 billion.
Berkshire’s maximum exposure is $37.0 billion, presumably if the four indices all fall to zero, but this isn’t going to happen so let’s look at more likely scenarios. We don’t know the details of how the puts are structured, but let’s assume the payouts are on a straight-line basis, such that if the indices are down 50% 13.5 years from now – another 17% from today’s levels – then Berkshire will have to pay $18.5 billion (half of the $37 billion maximum). That would be a painful loss, to be sure, but one that Berkshire could easily afford: the company’s earning power today exceeds $10 billion per year and, as of the end of October, its net worth exceeded $111 billion, both figures that will be much higher more than a decade from now.
It’s also important to understand that the loss in this doomsday scenario would not be $18.5 billion minus $4.85 billion because Buffett can invest the $4.85 billion for the entire period. If he earns a mere 7% return for 13.5 years, $4.85 billion becomes $12.1 billion (at a more likely 10% annually, it would be $17.6 billion). If we assume a 7% compounded return, Berkshire’s break-even point on this investment would be a 33% decline in the indices from the point at which the puts were written, meaning the indices would only have to increase less than 1% annually over the next 13.5 years to reach this from today’s level of down 40%.
I think it’s very likely that the indices will compound at 4% annually from today’s depressed levels, making it unlikely that Berkshire will have to pay out anything on these contracts. And given how much Buffett was paid to write them and his ability to invest the premium he was paid in any way he chooses, it’s even more unlikely that this will be a losing investment. Thus, even knowing what I know today, I think this was a fantastic investment and wish Buffett had written more of these contracts (perhaps he’s writing more today?).
It is critically important to understand that the derivative contracts Buffett sold cannot be exercised prior to expiration, nor does Berkshire have to post collateral when the CDS spreads widen and/or the indices fall. Thus, the company has virtually no liquidity risk.
So why do investors appear to have this concern? Most likely, they simply haven’t done their homework, or perhaps they are misunderstanding this disclosure in Berkshire’s Q3 10-Q:
Under certain circumstances, including a downgrade of its credit rating below specified levels, Berkshire may be required to post collateral against derivative contract liabilities. However, Berkshire is not required to post collateral with respect to most of its credit default and equity index put option contracts and at September 30, 2008 and December 31, 2007, Berkshire had posted no collateral with counterparties as security on these contracts.
I doubt Buffett would write any contracts that would require Berkshire to post collateral in the event of a downgrade, so I suspect that this disclosure relates to some of the legacy derivative contracts that Berkshire inherited when it acquired Gen Re. Buffett wisely shut down Gen Re’s derivatives business many years ago, however, and there are very few contracts remaining, so the risk here is immaterial.
Today, Berkshire spokesperson Jackie Wilson confirmed to Reuters that the company has “nominal” collateral requirements that would take effect were credit rating agencies to reconsider its triple-A rating, and said that collateral requirements would total “far below 1 percent of assets”. Assets were $282 billion as of Q3, so we now know that Berkshire’s total collateral requirements, in a worst-case scenario, are “far below” $2.8 billion.
Berkshire does have to book unrealized gains or losses every quarter on its derivative contracts (unlike changes in value in its much larger marketable securities portfolio), but these are noncash changes, as Buffett explained in the Q3 earnings release:
With very limited exceptions, gains or losses from marketable securities are recorded only upon sale. Berkshire has large amounts of unrealized gains, and sales are never made with an eye to their effect on reported earnings. During the first nine months of 2008, our unrealized gains fell by $7.5 billion (leaving us a total of $24.3 billion in unrealized gains at the end of September). That decline of $7.5 billion does not show in our reported earnings. What is included is a realized gain: $65 million pre-tax and $42 million after-tax.
In contrast, accounting rules require that any unrealized gain or loss from most of our derivative contracts be regularly recorded in earnings.
A final risk factor to consider is undisclosed risks – the type that have blindsided investors in so many other financial companies. It’s impossible to rule out unexpected surprises for any company, but anyone who’s studied Buffett will surely take comfort in his 50+ years of conservatism and openness with his investors.
To understand why it’s so unlikely that there might be hidden derivative bombs on Berkshire’s balance sheet, one needs to understand how Buffett thinks about risks like this. For example, here’s an excerpt from his 2002 annual report (page 14), in which he warns about the exact scenario that crushed AIG this year:
Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.
At $77,500, Berkshire’s stock today is the cheapest, by far, we have ever seen it, going back at least a dozen years.
We estimate Berkshire’s valuation the same way Buffett does: we value the investment per share (cash, bonds and stocks) at market and then place a 12 multiple on the pre-tax operating profits of the company (for more details on this as well as our entire analysis of Berkshire, see our presentation, which is posted here). As of the end of last year, investments per share were $90,343 and our estimate of normalized pretax earnings was $5,500-$5,700/share, which resulted in an estimate of intrinsic value of $156,300-$158,700.
As of the end of the third quarter, investments per share had fallen to $86,000 due to declines in the prices of stocks Berkshire holds as well as Buffett investing tens of billions of cash in a wide range of operating businesses. In light of the severe market decline in October and so far in November plus additional investments Buffett has made, we estimate that investments per share might have fallen to as low as $76,000.
As for Berkshire’s earnings, they are obviously impacted by the weak economy, but this is offset by the many new businesses Buffett has purchased. Over time, the many investments and acquisitions Buffett’s made this year will lead to much higher earnings, but for the next 12 months, to be conservative, let’s assume that pretax earnings are $5,000/share (assuming the severe recession continues and a normal super cat year). This results in an estimate of intrinsic value of $136,000, 76% above today’s level.
This slide from our presentation (posted here, page 12) shows Berkshire’s share price over the past 12 years, with each year’s estimate of intrinsic value:
One can see that Berkshire’s share price has, at some point during every year, reached intrinsic value except for 2005 and so far this year. One can also see how far below intrinsic value Berkshire is today.
Another way to think about Berkshire’s value is to consider that Berkshire’s share price today barely exceeds investments. Thus, today one can own the collection of fabulous businesses that Buffett has acquired over the years for less (pretty much for free).
In this environment, it’s not surprising to us that the stocks of companies with shaky balance sheets, poor business models and/or weak competitive positions are getting clobbered, but Berkshire’s freefall in the past few weeks is certifiably crazy – and a buying opportunity that will long be remembered.
Disclosure: Funds the author manages are long Berkshire Hathaway
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This article has 48 comments:
Kind Regards
"If these contracts were written by anyone else, I would be worried about substantial losses over the next few years, but given what I know about Buffett, I think it’s likely that this will prove to be a profitable investment."
...hmmmm -- what'd you say your stop-loss was?
CDS speculators are the new Enron pirates and they are simply attempting to create self fufilling prophecies anywhere they can. The sooner authorities wake up to this and close down the entire CDS circus act, the better for everyone. It is an entirely fantasy market unmoored from real anything at this point, and its gyrations have no more to do with underlying financial realities than a pinpall machine does.
On Nov 20 04:42 PM raytayzmd wrote:
> ...just got through looking at your mutual funds -- hmmm, down something
> like 70% in a only a year?...wow, did you pick pick a great time
> to start some mutual funds or what!...so much for getting a Harvard
> MBA!
I agree with your value.
Thanks for taking the time and sharing your knowledge with us
Instead of "drill-drill-drill" I think it is time to "buy-buy-buy".
As an owner since 1987 I find todays Berkshire price to value compelling . it is time again to add this to the portfolio.
On Nov 20 05:41 PM AEG wrote:
> Excellent review.
> I agree with your value.
> Thanks for taking the time and sharing your knowledge with us <br/>Instead
> of "drill-drill-dril... I think it is time to "buy-buy-buy"... <br/>As
> an owner since 1987 I find todays Berkshire price to value compelling
> . it is time again to add this to the portfolio.
On Nov 20 05:39 PM Terry Huebert wrote:
> I'm nowhere near down 70% yet and I'm just a bum from Moose Jaw Saskatchewan,
> with a BSc and a teaching diploma.
I am a big WB fan and I believe he will make money from his decisions. But, let's be consistent in our treatment. Good luck navigating this storm.
Nov 20 (Reuters) - Berkshire Hathaway Inc:
* says has 'nominal' collateral requirements that would take effect were credit rating agencies to reconsider triple-A rating - spokeswoman
* collateral requirements would total 'far below 1 percent of assets' - spokeswoman
On Nov 20 04:11 PM levin70 wrote:
> The only problem with your analysis is you don't know what happends
> to the collateral requirements if BRK looses its AAA rating. If
> that happends, my guess is just like AIG it must put up collateral.
> If that happends anytime over the next year, that collateral requirement
> could cause the liquidity crunch you don't think will happen.
>
>
> Kind Regards
I'm sorry but did you even bother to read the article? Specifically the author's SECOND posting of the language from the 10-Q (just in case you missed it the first time), after which he notes:
"Today, Berkshire spokesperson Jackie Wilson confirmed to Reuters that the company has “nominal” collateral requirements that would take effect were credit rating agencies to reconsider its triple-A rating, and said that collateral requirements would total “far below 1 percent of assets”. Assets were $282 billion as of Q3, so we now know that Berkshire’s total collateral requirements, in a worst-case scenario, are “far below” $2.8 billion."
I don't really understand how this could be any more clear. I guess you could argue that Warren has instructed Jackie to lie about it, which would be in keeping with Warren's horrible, horrible reputation over the past five decades.
And Terry, as for the derivatives coming back to bite him in the ass and Warren being right in the thick of things, did you even get to the part discussing Warren's having shut down Gen Re's derivatives business years ago? He's taken plenty of precautions with the contracts he's entered into this year, and perhaps you should check back in with Berkshire in 2019, when the first payments on the equity puts would have to be made. In the meantime, we'll watch with eager eyes for you to perhaps be proven right as every high yield company he's written CDS on defaults. Buffett says it's unlikely that happens, but who cares, for LO the mighty bum from Moose Jaw, Saskatchewan hath rendered his judgement!
For the love of God, people. Work on your reading comprehension.
that could be the reason for the decline? How about the loss in
value of its equity positions? The preferred warrants are underwater,
investors are questioning the viability of GS and its business model,
and the fact that many times investors sell what they can - brk is
not the most liquid of investments. Given WB's age then how many
PMs are willing to stick a large chunk of their assets on a bet of
immortality, or at least surviving thru the existing bear market. There's
alot of net-nets and more everyday that offer a potential better
value.
As smart as Ben graham was he lost something like 75% during the
29-32 bear market. It wouldn't be impossible for WB to endure the
same sort of loss if stocks declined further...though I'm not suggesting
they will.
smart...
It's not the fundamentals that brought the stock down.. It is because the sellers have been given many tools to kill any stock. Look at Citicorp, JP Morgan, Bank of America, Goldman, Lehman, etc. They went down hard and fast. In the old days, it never happened that way.
The SEC has been favoring the sellers for the sake of liquidity and free market. The SEC repealed the uptick rule. And now, they are not monitoring "dark pools" that flash across the electronic exchanges with mysterious large orders. These orders may be simply intra-day naked short-sales. These orders, in my opinion, may be closed out at the end of the day leaving no trace of illegal shorting. And then, there is unlimited shorting via the use of ETFs and put options. And then, there is also no regulation on the CDS market.
These instruments can help kill any stock any time.
Consider this strategy. Buy bonds and use the coupon by options on the CDS, and then short the stock using puts and aggressive shorting on the down tick to generate speed. Volatility increases, and it's all over before the stock knows it.
Mr. Buffett needs to talk to President-elect Obama to reintstate the uptick rule, and to get more transparency on "dark pools" and hedge funds. The market is running out of time!
In the 1999 report, WB wrote that he would consider buying back shares at prices under $45,000. I wonder what that threshhold price is now.
While the CDS' are blown out, i receive ads for municipal bond uit's rated AAA, insured by - you guessed it Berkshire Assurance Corp.
As we all know, the market is there to serve us, not to instruct us. I've been instructed enough. The price action of BRK is a symptom of market dysfunction. All the "improvements" to the marketplace instituted by regulators the past 20 years, selling short without a downtick, the effective elimination of human beings (computers are better?) as specialists, the allowance of these derivative products at all and the complete lack of regulation around them, and allowing investment banks to massively increase their leverage, were all huge mistakes. And now we're all paying for it.
BRK will survive this and i would wager eventually prosper from these terrible times. But, many many other fine corporations and their employees will lose their jobs - and that is a tragedy.
Where is the leadership in the midst of all this market dysfunction? The one piece of leadership I've seen is from Mr. Buffett - an exemplar in the midst of this - even with all the naysayers looking for a reason to point out that he's made a mistake. He rises above it - he does the right thing - it seems he's one of the few statesmen we have left.
Sadly, we are all suffering from a complete lack of leadership by the White House - save Hank Paulson, the Congress, and the SEC - where are the prosecutions around SARBOX non-compliance - didn't all these ceo's and cfo's certify as to the accuracy of these bizarre balance items?
Perhaps we're all wrong and equities hit zero.
What if Wall Street = Game Over...
I happen to be one of the little debt crowd that is ready to go all in -- but simply waiting for my multiples at this point.. 10x return vs 12x are not too far different in today's climate.
I've been a big fan of yours since back in the days of the Motley Fool and Dale Wettlaufer (mispelled?). I am not really familiar with CDS's and their trading activity, however, when the story ran yesterday a lot of the things you mentioned ran through my head. It was really nice to see such a well written piece that confirms and adds to some of my thoughts. I have been going around telling anyone I know that this is an opportunity that I have never seen, nor did I ever dream would see in my lifetime. I have 30 percent of my net worth in Berkshire and am thinking of going to 50.
Despite the crazy comments here which kind of explains the current environment, there are many of us out here who get what you are saying and appreciate greatly your efforts. Thank you so much!
Selling options will prove to be WB's biggest mistake. For someone who's criticized the derivatives market for so long, his massive scale put selling is perplexing. 4.5 billion at-the-money put premium received! Sold at the height of the market when volatility was the lowest! These European style options are always marked to market, margin calls are going to make poor WB sleepless. Not to mention the GS and GE investments he just made. Sorry to see WB in this state so late in his career...
This explains why everything related to the stock market seems strange and unpredictable. The manipulation relies on contrarian market movements. The normal players like Kerkorian, Adelson, Sovereign Wealth Funds, Buffett, Pickens, Falcone, Gendell, etc. will lose money, not because their research is flawed, or their supply/demand models are wrong, but because they are acting as expected, and the expectation fuels the mechanism upon which the conspiracy is based. Interesting, eh?
Yes. Tilson says you can own Berkshire "for free," but the truth is you're paying a premium. Maybe it's worth it to have Buffet and his team managing your money for you. But you're paying for that management.
I could get 4-5% virtually risk free. Is Berkshire's management really worth another 8.3% on top of that? Can Berkshire - or any company - really grow at that rate indefinitely? (How long before they own everything?)
The other thing - is - who are these counter-parties Tilson describes?
Who pays $3.2 billion in premiums to guard against "an extremely unlikely" $4.7 billion loss? I mean, I'm just a schmuck, but even I don't pay $32,000 to insure a house worth $47K.
And who pays $4.85 billion NOW on a bet that stocks will be worth LESS in 13 years? Where do they hide such financially-challenged billionaires?
Who are these guys, and how do I meet them?
Also, although put-writing business is not bearing unlimited risk, but compared to the premium he has collected, the built in leverage remains very large from 5 to 20, depending how close you're out of money.
Sure, European puts writing has no exercise issue, but based on its deminishing value, dealer/brokerage house may ask for more and more deposits or collaterals. And most importantly, hope until the maturity around 2019 or later, the world economy would not be as bad as now: if so, Buffett may lose his hard-earned pants if the strike price is high enough just like S&P at 1300+
In other words, you collect premium most of time, yet all of a sudden, you lose everything you bet and put writing and call writing belong to this category.
From this perspective, Buffett is not a good risk management investor but a pure speculator. Unless he has a cristal ball, nobody can see through 2019~2027, maybe Buffett can..
And, I will not have a lot of faith in Buffett until I hear some attempt to explain why he so strongly supported the original Paulson Plan and Paulson. Buffett and Paulson did not even agree on the Plan (Pauslon wanted to pay above market for the assets) and Paulson did not even implement the Plan. Was Buffett wrong or dishonest?
If only CNBC had some hungry journalists who would ask worthwhile questions.
...actually after yesterday I think they're down about 80% in one year...maybe Harvard'll give him a refund.
On Nov 20 05:39 PM Terry Huebert wrote:
> I'm nowhere near down 70% yet and I'm just a bum from Moose Jaw Saskatchewan,
> with a BSc and a teaching diploma.
On Nov 20 05:52 PM Terry Huebert wrote:
> Only 40% below intrinsic value doesn't cut it in a market where some
> companies are selling for less than their cash in the bank. In today's
> market I won't buy a company whose cash is less than their market
> cap. This is the new metric, this is the new margin of safety. Warren
> better get used to it and so should Whitney.
On Nov 20 06:02 PM Terry Huebert wrote:
> I checked on Yahoo Finance and their prices on BRK only go back to
> Jan, 1990. Since then it has been a 10-bagger. But "compelling" going
> forward has nothing to do with "lookin good" going backward.
On Nov 21 01:21 AM LinusK wrote:
> Quote: "I don't understand why you add a multiple of earnings to
> the value of the stocks and bonds he owns. Aren't the earnings coming
> from these stocks and bonds and are impounded in their values? "
>
>
> Yes. Tilson says you can own Berkshire "for free," but the truth
> is you're paying a premium. Maybe it's worth it to have Buffet and
> his team managing your money for you. But you're paying for that
> management.
>
> I could get 4-5% virtually risk free. Is Berkshire's management really
> worth another 8.3% on top of that? Can Berkshire - or any company
> - really grow at that rate indefinitely? (How long before they own
> everything?)
>
> The other thing - is - who are these counter-parties Tilson describes?
>
>
> Who pays $3.2 billion in premiums to guard against "an extremely
> unlikely" $4.7 billion loss? I mean, I'm just a schmuck, but even
> I don't pay $32,000 to insure a house worth $47K.
>
> And who pays $4.85 billion NOW on a bet that stocks will be worth
> LESS in 13 years? Where do they hide such financially-challenged
> billionaires?
>
> Who are these guys, and how do I meet them?
>
>
I'll bet Goldman Sachs sold him the derivatives.
Then they sold him the company.
Nice trade.
2. No way this was a 1:1 bet. You don't hand over $5 billion in cash if you only need want a 6% return.
3. What currencies are involved? He is not the oracle of currencies.
4. The equities within Berk are down plenty.
Methinks you are overcome by Buffetts recent Narcissistic tendencies.
What makes you think the max loss is 37 bn, the 10Q says this is the notional portfolio value. I ran some numbers and my quick and dirty estimate is a loss of 86bn if S&P was 0 at expiry. The puts were written close to market, lets say the strike was 1500 and market was 1500, the vol was 18%, with risk free rate of 3.75% and 15 yr term the fair val is about 81 pts (delta 0.1281) and if we have a premium of 4.66 bn and that is equivalent to 230,000 exchange contacts at $250 a point. So if S&P is zero the loss is 86 bn. I believe the notional portfolio value is the delta, divided into the premium (4.66/0.12181 = 36.4 bn)
Now at S&P = 800 risk free rate 3% long term vol 35% the time to run 13.5 yrs the put fair val is 538 pts (delta .33) and fair val 30 bn. Lets say there has been a 20% gain due to currency so net is 24bn the loss to be recorded for 2008 is 19 bn the notional portfolio (currency adjusted) is now (24/.33) = 73 billion.
This is why investors are running away.
Here's a simpler proposition for you -- the value of a European put option cannot be greater than the strike. Why? Well, at worst, the underlying security goes to 0, which results in a payout of (Strike - 0) when the option holder gets to sell something worthless for Strike dollars.
In fact, by applying basic logic, one can lower this ceiling to (strike - 0) x (discounting effect of receiving cash flows in the future), since one cannot receive the maximum cash flows until expiry, even if the index goes to 0 and stays at 0 today.
One corner case re: the above is that in an environment with negative nominal interest rates, the maximum payout might be (strike-0) x (inverse of the deflationary effect until option expires).
On Nov 22 05:43 AM djw wrote:
> > Berkshire’s maximum exposure is $37.0 billion,
> What makes you think the max loss is 37 bn, the 10Q says this is
> the notional portfolio value. I ran some numbers and my quick and
> dirty estimate is a loss of 86bn if S&P was 0 at expiry. The
> puts were written close to market, lets say the strike was 1500 and
> market was 1500, the vol was 18%, with risk free rate of 3.75% and
> 15 yr term the fair val is about 81 pts (delta 0.1281) and if we
> have a premium of 4.66 bn and that is equivalent to 230,000 exchange
> contacts at $250 a point. So if S&P is zero the loss is 86 bn.
> I believe the notional portfolio value is the delta, divided into
> the premium (4.66/0.12181 = 36.4 bn)
> Now at S&P = 800 risk free rate 3% long term vol 35% the time
> to run 13.5 yrs the put fair val is 538 pts (delta .33) and fair
> val 30 bn. Lets say there has been a 20% gain due to currency so
> net is 24bn the loss to be recorded for 2008 is 19 bn the notional
> portfolio (currency adjusted) is now (24/.33) = 73 billion.
> This is why investors are running away.
Here's a simpler proposition for you -- the value of a European put option cannot be greater than the strike. Why? Well, at worst, the underlying security goes to 0, which results in a payout of (Strike - 0) when the option holder gets to sell something worthless for Strike dollars.
In fact, by applying basic logic, one can lower this ceiling to (strike - 0) x (discounting effect of receiving cash flows in the future), since one cannot receive the maximum cash flows until expiry, even if the index goes to 0 and stays at 0 today.
One corner case re: the above is that in an environment with negative nominal interest rates, the maximum payout might be (strike-0) x (inverse of the deflationary effect until option expires).
In short -- his notional exposure is the maximum exposure
On Nov 22 05:43 AM djw wrote:
> > Berkshire’s maximum exposure is $37.0 billion,
> What makes you think the max loss is 37 bn, the 10Q says this is
> the notional portfolio value. I ran some numbers and my quick and
> dirty estimate is a loss of 86bn if S&P was 0 at expiry. The
> puts were written close to market, lets say the strike was 1500 and
> market was 1500, the vol was 18%, with risk free rate of 3.75% and
> 15 yr term the fair val is about 81 pts (delta 0.1281) and if we
> have a premium of 4.66 bn and that is equivalent to 230,000 exchange
> contacts at $250 a point. So if S&P is zero the loss is 86 bn.
> I believe the notional portfolio value is the delta, divided into
> the premium (4.66/0.12181 = 36.4 bn)
> Now at S&P = 800 risk free rate 3% long term vol 35% the time
> to run 13.5 yrs the put fair val is 538 pts (delta .33) and fair
> val 30 bn. Lets say there has been a 20% gain due to currency so
> net is 24bn the loss to be recorded for 2008 is 19 bn the notional
> portfolio (currency adjusted) is now (24/.33) = 73 billion.
> This is why investors are running away.
Here's a simpler proposition for you -- the value of a European put option cannot be greater than the strike. Why? Well, at worst, the underlying security goes to 0, which results in a payout of (Strike - 0) when the option holder gets to sell something worthless for Strike dollars.
In fact, by applying basic logic, one can lower this ceiling to (strike - 0) x (discounting effect of receiving cash flows in the future), since one cannot receive the maximum cash flows until expiry, even if the index goes to 0 and stays at 0 today.
One corner case re: the above is that in an environment with negative nominal interest rates, the maximum payout might be (strike-0) x (inverse of the deflationary effect until option expires).
In short, max exposure = notional value. or less.
On Nov 22 05:43 AM djw wrote:
> > Berkshire’s maximum exposure is $37.0 billion,
> What makes you think the max loss is 37 bn, the 10Q says this is
> the notional portfolio value. I ran some numbers and my quick and
> dirty estimate is a loss of 86bn if S&P was 0 at expiry. The
> puts were written close to market, lets say the strike was 1500 and
> market was 1500, the vol was 18%, with risk free rate of 3.75% and
> 15 yr term the fair val is about 81 pts (delta 0.1281) and if we
> have a premium of 4.66 bn and that is equivalent to 230,000 exchange
> contacts at $250 a point. So if S&P is zero the loss is 86 bn.
> I believe the notional portfolio value is the delta, divided into
> the premium (4.66/0.12181 = 36.4 bn)
> Now at S&P = 800 risk free rate 3% long term vol 35% the time
> to run 13.5 yrs the put fair val is 538 pts (delta .33) and fair
> val 30 bn. Lets say there has been a 20% gain due to currency so
> net is 24bn the loss to be recorded for 2008 is 19 bn the notional
> portfolio (currency adjusted) is now (24/.33) = 73 billion.
> This is why investors are running away.
Who was buying at 475bps? I cannot imagine that they were forced to, given that most banks do not account -properly- for Credit risk when dealing with AAA counterparties... such exposure, in such times, would be the last one they would be focusing on and forced to cut.
It is so easy to argue that this is a distressed level, which can't be used for MrkToMkt purposes... The FSA allowed that when Lehman's portfolio was offloaded... so who was (cf the above, silly or deseperate enough) to hedge such risk at such level? Why weren't there more sellers, some -new- funds are flush with cash and this would have been a great trade to put on....
Thanks
For those bashing Whitney, regardless of how far his holdings are down at the time you looked, the fact is he's a "value investor!" He doesn't run to the hills when the market value of his current portfolio goes down. On the contrary, like any good value investor, he opens up the cash supply, smiles broadly, and begins buying up wonderful companies that others are throwing away (BRK and KO come to mind).