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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 (NYSE: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 (NYSE:TRV), 3x JP Morgan Chase (NYSE:JPM) and well above Citigroup (NYSE: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???

Why Are Investors Panicked About Berkshire?

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:

Q3 Earnings

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.

Derivative Contracts

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.

Buffett elaborated on this in the Q3 earnings release:

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.

So writing these derivative contracts was a horrible idea, right? Not so fast…

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?).

Liquidity Concerns?

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.

Valuation

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

Source: Berkshire Hathaway Credit Risk, Index Puts Are Overblown Worries