Berkshire Hathaway Credit Risk, Index Puts Are Overblown Worries

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???

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

Comments

[Kospi:]

I agree with Tilson's conclusions and am a big Buffett fan. He knows how to manage risk and understands the "Black Swan". My only criticism is why do this at all and create confusion. He long predicted a market meltdown from derivatives and the great values it would produce. It's not like there is a shortage of opportunities. Sometimes, smart guys try to get too cute. I suspect the puts will turn out to be a good investment. However, he risks damaging Berkshire's greatest asset, their reputation and perception of strength in the worst of times.

2008 Nov 21 06:04 AM

[MaverickBian:]

Just wonder, $4.6bn in CDS premium collection only pays out $4.7bn in the worst case scario. Maybe Buffett thought current market has reached the bottom, just like his investments in GS and GE cases.

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+

2008 Nov 21 06:14 AM

[MaverickBian:]

By the way, put writing and call writing is not favored by the hedge fund world. because these two investment strategies are 100% gamblers' speculation, no risk management at all, especially for call-writing one whose risk is unlimited.

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..

2008 Nov 21 06:20 AM

[IJR:]

I find it hard to reconcile your projections of a possible payout being due on the puts; that is, the market is flat to down over the remaining life of the contracts, with your assumption that BRK will earn 7-10% return over this period. I realize we all think WB is the greatest investor ever, but if we are looking at a scenario where these puts are well in the money, I think anyone would have trouble making decent returns over that time period. Your analysis is inconsistent in that regard. By the same token, I would say it is reckless for WB to invest the proceeds of the put sale in the market, as this is effectively doubling up on his bet. People are ridiculing AIG now for taking the proceeds of CDS contracts written and investing them in the mortgage backed market itself. Is this not the same behavior?

2008 Nov 21 09:10 AM

[Erich Riese...:]

I understand the desire to be comfortable with everything Buffett, but still, even if these derivatives don't cost Berkshire too much money in absolute terms, isn't the timing of their sale a huge opportunity cost? Woudln't Mr Buffett's reputation be so much better if he were selling this insurance now, at higher prices?

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.

2008 Nov 21 10:27 AM

[raytayzmd:]

...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.

2008 Nov 21 10:41 AM

[AEG:]

If I understand your investment process, you will only invest in those companies that have more cash than market cap. Without the liability part of the balance sheet, you may run into a problem. Thus, GM has 19.5 b in cash vs its market cap of 1.76 b.


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.

2008 Nov 21 11:16 AM

[AEG:]

I purchased one share of Berkshire for $ 3,200 in 1987 (the now "A" issue) and at the time ,if I remember correctly the price to value based upon my calculation was greater then compared to now. Thus my previous comment is actually looking forward. it is a better buy today relative to my purchase in 1987.


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.

2008 Nov 21 11:22 AM

[zaparozhe:]

They are insurance cos who hedged the guarantees that they gave their "equity-linked" annuity holders. Those that did not hedge are now having great difficulty taking mtm losses on their obligations (Hartford, Pru et al).


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?
>
>

2008 Nov 21 12:03 PM

[dlaw:]

I'll bet Goldman Sachs sold him the derivatives.

Then they sold him the company.

Nice trade.

2008 Nov 21 08:27 PM

[jcrash:]

1. You say worst case his indexes are down 40% since the put sell. You sure? Did he sell Russian/Icelandic/Hong Kong? India? Plenty of indexes are off WAY more than 40%. He may well need a 150-200% market run in the intervening years.

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.

2008 Nov 21 10:08 PM

[djw:]

> 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.

2008 Nov 22 05:43 AM

[User 304437:]

Um, no...that might be why...innumerate investors are running away. Seriously, chill w/the voodoo math.

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.

2008 Nov 22 05:58 PM

[cellardoor1:]

Um, no...that might be why the innumerate investors are running away. Seriously, chill w/the voodoo math.

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.

2008 Nov 22 06:02 PM

[cellardoor1:]

Um, no...that might be why _innumerate_ investors are running away. Seriously, chill w/the voodoo math.

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.

2008 Nov 22 06:04 PM

[drone:]

Who is the person going around putting thumb down on all negative comments and thumb up on positive ones. Is it Whitney? I think it is Warren himself in the flesh with his thumb.

2008 Nov 23 07:42 AM

[Matcs:]

What is roughly the current credit spread on BRK? Did it come down to earth? Is there a steep term structure?

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

Feb 05 07:48 AM

[oldlures1:]

This just makes me all giddy inside. I've got one word for you: "karma"

Mar 10 04:14 PM

[U338129:]

The only concern I have with my BRK stock is the obvious, Mr. Buffett's and Mr. Munger's longevity. I will be at the meeting next Saturday (love the cowboy theme on passes) and I'd love to hear a bit more on Berkshire post-Cowboy 1 and Cowboy 2. They won't tell us; but, it sure would help. One has to wonder what type of hit BRK shares will take when Buffett is no longer contribute.

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).

Apr 23 02:01 PM

[U338129:]

No longer "able to" contribute.

Apr 23 02:02 PM