Berkshire Bond Yields vs. CDS Rates

Apparently everyone is very excited over the CDS rates being quoted upon a default of Berkshire Hathaway (BRK.A). Forbes has reported it and it appears to be talked about all over the blog world by numerous commentators.

But I have yet to see is any discussion about the yield on bonds of Berkshire Hathaway. We have to remember, there are various buyers in the market. A buyer of CDS insurance is not necessarily a buyer of their bonds, nor stock, etc. In fact, these are the types of things that are often most interesting to look for, a discontinuity in the marketplace. I have to say, this is a big one. Why?

A trip over to FINRA will show people interested in this type of thing something far more interesting. The yields on the CDSs are about equivalent to the actual bonds themselves. So, an insurance writer can sit on the full amount of cash and get some amount of yield there, sell CDS protection on BRK, sell the equivalent amount of bonds and sit around and with the original cash balance at the RFR and sit with the cash from the short at the brokers cash rate. However, collecting interest on the two combined on top of the CDS while having 100% full protection from the short is a pretty compelling trade if you ask me. It's called free money. Real, economical, pure free money.

So, there are a few thing to ponder as we look at this discontinuity and whether or not BRK is truly in junk bond status. We need to try and come up with an answer as to which is right, the CDS market or the bond market, which presents the following questions:

1. Which is more liquid?
2. Which is in more turmoil?
3. Which has more questions over counterparty risk, making perhaps the number of acceptable sellers to be minimal and more valuable?
4. Which is in the midst of shriveling up because it needs to be moved over to an exchange before anyone will trade much anymore?

So as everyone freaks out over BRK CDS spreads, let's understand that just because it's a very disturbing and exciting thing to happen and thus seems very newsworthy, that in fact the analysis of what the CDS market says is stopping short of any sort of useful analysis at all. Perhaps this is the problem. Actually going through and pointing out that the bond yields say something very different might make the "oh my gosh" factor dwindle. Because maybe, just maybe, what's really happening is some huge institution probably has a big need to hedge out their risks and somewhere there are traders taking advantage of that. That's the way this game works. Forced buyers in illiquid markets get screwed, just as badly as forced sellers. Look at what happens to mutual funds at the end of every day they finally figure out how big their redemptions are going to be. Traders are sharks and the minute they smell blood, they will devour you. My guess is, someone really wants insurance and probably not because they own BRK bonds, perhaps they own some of those terrifying derivative positions Buffet wrote which have gone up in value.

So, looking at the bond market, it says BRK is one of the strongest companies around.... still. It trades lower than the average Moody's AAA rated company by what appears to be about 133 basis points. Now let's ponder what this says about what's going on in the rest of the market. It appears that this is yet another sign the world is going to end. But yet, the world is not going to end and the Great Depression is not here. The Great Depression required people to take all of their money out of the banking system causing a gigantic contraction in the money supply, causing a massive contraction in the economy.

So let's all ask ourselves.... do we really believe that everyone is about to put their money under a mattress, which is one of the core problems of the GD? We may move it from a weaker bank to a stronger, maybe even attempt to move it offshore (try Europe, I hear the banks are in great shape there too!!), but we are in far more danger of being Japan. But Japan started out being priced like the Nasdaq, with a bunch of not very compelling companies that don't allocate capital very well at all and have done nothing to rationalize their economy during the downward spiral and in fact have basically attempted to keep the status quo. Real GDP has in fact grown. So, the comparison doesn't really work completely since part of the problem of Japan is understanding the scale of the bubble and the mismanagement of the economy and capital allocation at a business level ever since. The similarity is that the US consumer is going to have a long time to have to repair their balance sheet and we may experience a deflationary period. How the incoming administration behaves towards mimicking mistakes made in the GD and Japan are interesting possibilities. But that is about it. Deflation of -1% is a far cry from -10%. It won't happen.

The rates on CDSs should actually be a tip off that what's going on is pure mayhem. The markets are having trouble holding together. We can argue about whether or not that is a bullish or bearish sign. My bet is calmer days will eventually be seen.

Disclosure: Author is long Berkshire Hathaway as of Friday.

Comments

[DonSuper:]

Finally! Someone that makes sense!

2008 Nov 23 12:37 PM

[dlaw:]

"Real, economical, pure free money." - incredible. Something about Warren Buffett causes people to live in a complete fantasy world.

But the author does show exactly why the CDS are so expensive: CDS are not only a default aritrage, they are also a spread arbitrage. While there are credit spread swaps (which would be the more-precise way to play a spread arbitrage) apparently CDS are the larger market.

If BRK bonds are trading at a premium to the AAA market, then CDS are a perfect way to play the arbitrage between BRK bonds and the AAA market. Since the derivatives losses seem a no-brainer to at least move BRK bonds down 133 bp - as the author notes - there is a nice, built-in cushion to the downgrade/default play.

So thanks to the author. Sometimes you can learn what's right by reading what's wrong.

2008 Nov 23 04:25 PM

[kdo:]

Hate to point out to you dlaw, but my sample arbitrage requires nothing to happen and is a risk free arbitrage. Try reading it again. Yours requires a downgrade and increase in BRK yields which has not happened yet and is thus a guess. Mine is a true arbitrage, yours is a bet and thus not arbitrage. Someone making your bet would be much better off simply shorting the bonds, because CDS are so expensive.

btw - let's explore CDS is a "larger market". Let's imagine for a moment, that if I bought a derivative of a bond from you. We'll call it a derivative since it won't be the actual bond itself, even though it will function 100% the same as the underlying bond itself. Now, I have a notional exposure of the total position and so do you. Bonds are worth $1 million, notional exposure is $2 million, since we both have a position. Then I trade it to someone else, perhaps even you at a different rate to adjust for yield changes. Notional exposure is now $4 million over the $1 million bond equivalent and now we just have a small spread yield payment in between us. On it goes every time it's traded including anyone else who comes into the trades. It's still just a $1 milion bond. The notional exposure means more about trading activity than it does about real exposure. How big do you think the bond market or stock market would be for that matter if notional exposure multiplied by two every time it was traded and was simply added to all other "notional" value of every trade made? Bigger than GDP? So much bigger than GDP it would be ridiculous to think it has any meaning to derive from the number?

04:25 PM dlaw wrote:

> "Real, economical, pure free money." - incredible. Something about
> Warren Buffett causes people to live in a complete fantasy world.
>
>
> But the author does show exactly why the CDS are so expensive: CDS
> are not only a default aritrage, they are also a spread arbitrage.
> While there are credit spread swaps (which would be the more-precise
> way to play a spread arbitrage) apparently CDS are the larger market.
>
>
> If BRK bonds are trading at a premium to the AAA market, then CDS
> are a perfect way to play the arbitrage between BRK bonds and the
> AAA market. Since the derivatives losses seem a no-brainer to at
> least move BRK bonds down 133 bp - as the author notes - there is
> a nice, built-in cushion to the downgrade/default play.
>
> So thanks to the author. Sometimes you can learn what's right by
> reading what's wrong.

2008 Nov 24 11:26 AM