Buffett Serving Free Lunch?

There has been a lot of talk about how it's okay that Warren Buffett has lost billions on his 2007 equity put options, because somehow this loss is just a “loss”. It's not a real loss, just a hypothetical loss.

Okay, then where did the money come from?

I ask because the (minimum) net $3-4 billion unrealized liability loss that Berkshire Hathaway (BRK.A) must book on the puts as of this writing represents real money that is right now, really, truly in the pockets of some very happy traders.

Actually, it only represents part of the profit. Only part, because not only have these options been an absolute disaster in terms of the losses on the indices they represent (and therefore the cash liability), but the real market price of the options has vastly increased since Berkshire sold them so unwisely, as volatility has nearly tripled since that time. You can make your own speculative calculation as to how much long-term, European-style, index options increase in price as the VIX goes from 25 to 75, but I think you'll find it to be an amount fairly described as a “pretty penny”.

And as sure as you are reading this, the trader or traders who took the other side (and thereby took Warren Buffett to the cleaners) have netted out their positions, selling the Omaha Oracle's odious options and putting pretty penny in pocket for a huge, very-much-realized, CASH profit.

Where did that cash come from? Does the Buffett buffet now serve an economic free lunch? Is Warren Buffett not only smart but an actual magician?

No, of course not.

This talk of Buffett's being able to invest the original premium and everything being okay in the end is nonsense. At the very least, Berkshire's derivatives disaster has dramatically increased the leverage of an already-leveraged company. One way or another, Berkshire Hathaway MUST deliver an economic premium to the marketplace for this loss.

Folks, a real, actual, cash profit of billions has been made on these puts. That money had to come from somewhere. I'm pretty sure I know where it came from: the pockets and purses of Berkshire Hathaway shareholders.

Hence, I think, the dramatic decline in share price.

Disclosure: no positions

Comments

[najdorf:]

The "real money"/"cash prices" that you refer to do not come from BRK, which, as you know and even state, has recieved only cash and registered only paper losses on this deal. It's possible that traders who bought puts have now sold their own puts at today's higher prices, or otherwise netted a profit - but they didn't sell to BRK. They sold to scared investors who think the right to sell the S&P at 750 or 850 far in the future has real value. The cash comes out of their pockets, not BRK's.

When stock markets rebound at some point in the next ten-twenty years we'll all say "Oh, who could have known that this would happen?" If stock markets don't rebound in the next ten-twenty years, show me an investing strategy that would have worked better without exposing one to huge risks (e.g. being short only).

Also, you're not the only offender, but I'm a bit tired of the endless Buffett/Berkshire confusion. Warren Buffett is not Berkshire Hathaway - he is its leader and a large shareholder, but there are many other shareholders and a few other people who work at the company, such as Charlie Munger and all the insurance subsidiary guys who consult on investments.

2008 Nov 23 11:50 AM

[SteveR:]

Agree with the above comments wholeheartedly. This is at least the 4th article I've seen here on seeking alpha that, quite frankly, shows a complete lack of understanding of the big picture and the fundamental transactions that are involved here. What are the qualifications required to get to print here? I would not consider myself qualified at all to speak on the subject but this commentary is well below my level of understanding.

Yes, Buffet's derivatives have lost value because he did not time this transaction correctly, but he has stated over and over again that he can not predict the short term gyrations of the market. And, come on, who could have predicted the timing and magnitude of what has happened in the last two months, are you kidding? From Buffet:

"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."

Do you understand? really understand??? If you did, and gave a compelling argument for the change in intrinsic value then I would have no beef.

As mentioned in the comment above, BRK shareholders have not lost yet. They are just down 2 touchdowns in the first 4 minutes of the 1st quarter. You are on the other side taunting and celebrating unblushingly. Unaware of the 56-14 route that is about to come!

2008 Nov 23 12:51 PM

[dlaw:]

I'm sorry, but I must respond to the last comment.

***I*** don't know anything? I?

First, this is a question. Money has been made. A premium, therefore, must be delivered to the market. I ask where the readers think this premium comes from and how it affects BRK. Is the loss probabilistic? Yes. Does that mean it's unreal? No. Clearly it is real. The idea that "in the long run it always goes up" is exactly the kind of unrigorous thinking that got America in this mess. Remember when real estate "always" went up?

Forget the Brooklyn Bridge - I've got a development in the Imperial Valley I'd love to sell to anyone who still thinks that way.

I regularly read the most ridiculous things about Buffett which add up to the same, spurious conclusion: "Buffett can't be wrong, because he's Buffett." I read recently how it's okay that the options have gone tragically from at-the-market to out-of-the-money because there is less vega loss as options go out of the money. By this "reasoning" if the indices lose another 40% Berkshire has scored some vega coup.

If a batter gets down 2-0, that batter is not out, but he has lost an immense amount of the probability of success. As such he "loses" much of the plate. It weakens his position as this derivatives disaster has weakened Berkshire's position.

The people who took the other sides of these trades were not children. They were not idiots. They knew they were betting against one of the best investors in history and they - not he - won. How do I know?

They have money in their pockets and Berkshire has losses on its balance sheet and that is the final arbiter of who wins and loses in the game Buffett plays.

There is no free lunch.

2008 Nov 23 04:16 PM

[JohnnyW:]

Berkshire has earned 4.85 billion in premiums, and these funds can be invested and earn income.
The puts are "European" options which are not exercisable until they expire.
These are long-dated puts, with expiration dates falling between 2019 and 2027.
Until they expire the puts have NO economic impact on Berkshire.

2008 Nov 23 11:43 PM

[Muzie:]

"***I*** don't know anything? I? "

Hmm, no, apparently, you don't. As it's been stated a million times before, the puts are non-exercisable before expiration. Please look up "non-exercisable" in a dictionary. Buffet got the premiums, and he doesn't pay up until the options expire (15 years from now).

Looks like it needs to be broken down in little bitesize pieces. for you. The flow of cash:

- Buffet engages in contracts with counterparty.
- Buffet receives premiums = cash flows to BRK.
- Market tanks. Contracts are quoted at a higher value on open market. Counterparty offers to sell contracts at higher ask. Cash flows to counterparty.
- Other counterparties engage in trade, exchanging cash. BRK does not trade its own contract.

Get it?

Your spurious argument about "the market may not be higher twenty years from now" is irrelevant. The market is down now, not twenty years. When the market is still at S&P 1200 twenty years you can come back here and strut your stuff - but it has NOTHING to do with the current decline.

Did you really expect Buffet to engage in these contracts at a twenty-year low and they would NEVER get in the money for twenty years??? You must be some kind of magician - whenever I write options, most of them do end up being in-the-money at least momentarily, ESPECIALLY long-dated ones.

Anyone who studies the markets expects the market will crash at some point over a twenty year period - always has, always will. And in fact crashing early on when the puts have just been written is actally the least detrimental to the reported losses, because the delta on them is low as the time value is quite high.

2008 Nov 24 03:00 AM

[Fran the man:]

I refer you to an articles written by Mr Buffett (it was actually a speech he had made earlier in 1999 distilled into an article published by Fortune the same year).

homepage.mac.com/bobem...

My personal view is that this is the only article one ever needs to read to understand the fundamental drivers of any financial asset (and specifically stock valuations).

Any one who wants to understand his thinking in structuring the options (and I can promise you he did it without ever looking a Black Scholes valuation model) and the real economic implications for BRK.

Interesting fact about the article referred to above; it was written when the Dow Jones Industrial Average was at c. 9150. Last I checked it was at c. 8200. Remember this was in the heady days of the Internet Bubble when books entitled: Dow Jones 36 000 were in vogue and everyone had their 401k's in Pets.com.

He was right then and I'm willing to write you a binary option he'll be right again.

2008 Nov 24 11:09 AM

[raytayzmd:]

...however, that put sits on BRK's balance sheet its entire lifespan and has a negative effect since it has to be accounted for...presumably, that currently has a negative effect on the company's credit worthiness and increases costs associated therewith...a pertinent question is how much effect will that be?

2008 Nov 24 11:21 AM

[Fran the man:]

Yes, you are right, BRK will have to recognise the liability on their Balance Sheet and mark-to-market/model the “fair value” movements in these puts.

However, from a credit worthiness perspective, the approach the ratings agencies (who are the final authority when it comes to credit risk) will take would be to look at the terms and tenor of the obligation. BRK has written these at-the-money puts for a duration of 15 years (minimum) and does not have a present obligation to settle this “debt”. Remember there is a condition probability here a.) firstly the indices must close below the agreed value, and b.) should this occur BRK must pony up the cash to the extent the puts are in the money (for the counterparty). BRK can only ever default on this obligation (should it be in the money for the counterparty) in 2019 and longer dated debt carry a much lower weighting than shorter dated debt in assessing credit risk (to clobber this point to death: BRK cannot default on this obligation for 11 years still).

Secondly, and more importantly, what all this illustrates is the inherent limitations of accounting (don’t get me wrong accounting is imperative for the proper functioning of capital markets, but will never be an exact reflection of economic reality). This BRK put is a case in point: the question here is what is the economic reality for BRK? Let’s take the S&P500 put as an example, firstly obviously Mr Buffett is bullish about the prospects of the American economy (and probably an increase in inflation) with a resultant increase in the underlying nominal earnings of the S&P500. During 2004 (when these options would have been written) the S&P500 earned c. 63 per unit and S&P500 was trading at 1150 (the S&P500 on was trading at or slightly above its long run historical average in terms of. price earnings, price-to-book, price-to-sales etc.).

Should nominal GDP growth in the US average 5% p.a. (say 2.5% inflation, 2.5% real GDP growth) the S&P500 would earn 131 p.u. in 2019, at 1150 this would translate into a PE of 8.8. The S&P500 has traded at this multiple or lower only 35 quarters out of 288 (i.e. since 1936). Although possible it is not probable. Also bear in mind that the S&P500 is subject to survivorship bias i.e. if a company loses a big chunk of its value a new, higher valued, company will be included, introducing a upward bias to the S&P500 (and an additional benefit for BRK) vs. e.g. a single stock reference asset.

The above illustrates the practical reality, BRK’s thinking and the economics. With respects to the real cash flow argument there is truth to the argument that traders will be able to sell these puts at the prevailing market price to other traders. That is exactly it: other traders, the real patsies are the traders trading this thing because at some point, like all other market inefficiencies, it will correct and pity the poor sole stuck with it who bought it using historical volatility to value it instead of looking forward.



On Nov 24 11:21 AM raytayzmd wrote:

> ...however, that put sits on BRK's balance sheet its entire lifespan
> and has a negative effect since it has to be accounted for...presumably,
> that currently has a negative effect on the company's credit worthiness
> and increases costs associated therewith...a pertinent question is
> how much effect will that be?

2008 Nov 25 05:51 AM

[raytayzmd:]

This guy better explains what I'm getting at:

"He (Buffett) has the cash, he doesn't have to post collateral (we hope), he's comfortable that in 18 years the market will be 65% higher, and he claims he doesn't care about the mark to market risk. I'm not sure he thought it through completely though: even if he has no collateral issues, the action of the person covering themselves against his risk certainly does, and that person is screwing up Warren's ability to finance himself elsewhere."

crookery.blogspot.com/...


On Nov 25 05:51 AM Fran the man wrote:

> Yes, you are right, BRK will have to recognise the liability on their
> Balance Sheet and mark-to-market/model the “fair value” movements
> in these puts.
>
> However, from a credit worthiness perspective, the approach the ratings
> agencies (who are the final authority when it comes to credit risk)
> will take would be to look at the terms and tenor of the obligation.
> BRK has written these at-the-money puts for a duration of 15 years
> (minimum) and does not have a present obligation to settle this “debt”.
> Remember there is a condition probability here a.) firstly the indices
> must close below the agreed value, and b.) should this occur BRK
> must pony up the cash to the extent the puts are in the money (for
> the counterparty). BRK can only ever default on this obligation (should
> it be in the money for the counterparty) in 2019 and longer dated
> debt carry a much lower weighting than shorter dated debt in assessing
> credit risk (to clobber this point to death: BRK cannot default on
> this obligation for 11 years still).
>
> Secondly, and more importantly, what all this illustrates is the
> inherent limitations of accounting (don’t get me wrong accounting
> is imperative for the proper functioning of capital markets, but
> will never be an exact reflection of economic reality). This BRK
> put is a case in point: the question here is what is the economic
> reality for BRK? Let’s take the S&P500 put as an example, firstly
> obviously Mr Buffett is bullish about the prospects of the American
> economy (and probably an increase in inflation) with a resultant
> increase in the underlying nominal earnings of the S&P500. During
> 2004 (when these options would have been written) the S&P500
> earned c. 63 per unit and S&P500 was trading at 1150 (the S&P500
> on was trading at or slightly above its long run historical average
> in terms of. price earnings, price-to-book, price-to-sales etc.).
>
>
> Should nominal GDP growth in the US average 5% p.a. (say 2.5% inflation,
> 2.5% real GDP growth) the S&P500 would earn 131 p.u. in 2019,
> at 1150 this would translate into a PE of 8.8. The S&P500 has
> traded at this multiple or lower only 35 quarters out of 288 (i.e.
> since 1936). Although possible it is not probable. Also bear in mind
> that the S&P500 is subject to survivorship bias i.e. if a company
> loses a big chunk of its value a new, higher valued, company will
> be included, introducing a upward bias to the S&P500 (and an
> additional benefit for BRK) vs. e.g. a single stock reference asset.
>
>
> The above illustrates the practical reality, BRK’s thinking and the
> economics. With respects to the real cash flow argument there is
> truth to the argument that traders will be able to sell these puts
> at the prevailing market price to other traders. That is exactly
> it: other traders, the real patsies are the traders trading this
> thing because at some point, like all other market inefficiencies,
> it will correct and pity the poor sole stuck with it who bought it
> using historical volatility to value it instead of looking forward.
>
>

2008 Nov 25 11:50 AM

[Fran the man:]

Fair point, provided BRK accesses public markets for debt and such debt is priced with reference to the BRK's CDS spread. However, BRK uses very modest levels of conventional gearing and, in its main business of insurance, credit ratings from the ratings agencies remain all important.





On Nov 25 11:50 AM raytayzmd wrote:

> This guy better explains what I'm getting at:
>
> "He (Buffett) has the cash, he doesn't have to post collateral (we
> hope), he's comfortable that in 18 years the market will be 65% higher,
> and he claims he doesn't care about the mark to market risk. I'm
> not sure he thought it through completely though: even if he has
> no collateral issues, the action of the person covering themselves
> against his risk certainly does, and that person is screwing up Warren's
> ability to finance himself elsewhere."
>
> crookery.blogspot.com/...
>

2008 Nov 25 12:52 PM

[immortal:]

If derivatives are weapon of mass destruction so why did Buffet involve in options writing business ?

2008 Dec 08 09:29 AM