Berkshire's Puts: Not Such a Great Idea

Andrew Clavell delves into the murky world of Berkshire Hathaway's (BRK.A) equity put contracts, and concludes:

The put owner has been forced into purchasing a lot more credit cover in a nasty cross gamma effect. No wonder BRK's credit spreads have gone bananas; they will likely remain volatile as there is a short cross gamma hedger out there for the next 20 years.
Moreover, as a result of the credit hedger's scramble for CDS protection, his mark to market on the original option is potentially worth only half the value had he been fully collateralised.

And you thought Warren Buffett was clever. In hindsight, he clearly never hedged against the impact of creating a short cross gamma hedger.

What's more, there's a good reason for the hedger to be cross: thanks to his hedging, his $4.5 billion put is today worth only $5 billion, despite the fall in the market and the rise in volatility. If only he'd got some collateralization, it would be worth $10 billion, and he'd be much more likely to get a hefty annual bonus.

It'll be interesting to see how the details of how Buffett values the put in his next annual report. Although Berkshire's CDS spreads make the put worth only $5 billion to the hedger, it's still a $10 billion liability to Buffett, at today's volatility levels. What's more, the $4.5 billion that Buffett received for selling the put is almost certainly worth substantially less than that today, especially if Buffett invested it in Goldman Sachs (GS).

Whitney Tilson still thinks this was a spectacular deal for Buffett:

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).

I find this unconvincing, because Tilson ignores the fact that Buffett's investments are highly correlated with the stock market as a whole. Even the biggest Buffett fan, I think, would have a certain amount of difficulty swallowing the idea that Buffett can get a +10% annualized return on his $4.85 billion over a long period of time in which the stock market falls by 50%.

I don't think the equity puts come anywhere near to threatening the future of Berkshire Hathaway. But equally, I'm not at all sure they were such a great deal for Buffett: not only did he write puts at the top of the market, but he also invested the up-front premium at the top of the market as well, raising a significant possibility that he would lose money on both the puts and his investments simultaneously.

Disclosure: Author has no position.

Comments

[Sage of Sug...:]

I don't know who this guy is, or what his reputation is. What is Cross Gamma Effect--seems like something from nuclear science. No wonder Buffett and Munger pay no attention to these esoteric and meaningless ideas.

Sure, looking back, the puts were not such a great idea. But even WORST case--all pertinent indexes down to ZERO--would reduce future book value of BRK by 15 to 20 percent. An unpleasant, but far from disastrous scenario. But then again, no one expects the indexes to go to ZERO.

Does this guy read the annual reports? Sure, BRK's EQUITY INVESTMENTS are highly correlated to the market. But in recent years the company's income from its operating businesses far outweigh the growth in equity investments. And the Operating businesses are doing just fine.

Focusing on the put option issue is like the guy who is unable to enjoy the Christmas lights because he is so distracted by the one string that is not lit.

2008 Nov 25 05:24 PM

[Praveen Ghanta:]

The author also ignores that BRK and Buffett have outperformed the market as a whole, and consistently, over decades. To be precise, from 1990 to today, BRKA has delivered compound growth of 16% per year, while the S&P has delivered around 7% with dividends.

9% of outperformance per year shows that Buffett can likely earn back the entire loss with the upfront $4.5B alone. And that's assuming that the market is still down 50% in 14 years.

2008 Nov 25 06:25 PM

[DonSuper:]

bla bla bla...
this article is nonsense...

2008 Nov 25 06:29 PM

[1 of 4:]

Felix, Buffet's investment in GS was a preferred investment with a 10% coupon that's a tax free dividend yield to a corporate like BRK-A. With that he got warrants for GS stock priced at $115. Yes the warrants are way out of the money, but Buffet has lost nothing on his investment in GS. Claiming that he has lost money on his position in GS is factually incorrect and only highlights your ignorance.

2008 Nov 25 09:40 PM

[AlexR:]

The yield on that Put seems awfully small for a 20-year out expiration. You can write much shorter options for a better premium. For example as of today, you could write the JUN 09 $85 PUT on SPY for $11.65. That's a 20% better yield than what Buffet got, in only 7 months as opposed to 20 years. Puts were cheaper a few months ago, but not by that much (especially not the ones further out). Was Buffet asleep on this one?

2008 Nov 25 11:41 PM

[najdorf:]

Alex: As has been discussed many times, they're European-style puts, exercisable only as expiration. The whole point of the investment was that the length of the option prevented any short-term market risks. BRK has sold someone an insurance policy against long-term stock market depreciation. As always, the company continues to operate as a moderately bullish long-term stock-market investor that attempts to take short-term volatiiity or risk in order for long-term profits in excess of what it will have to pay out in insurance.

Of course BRK could have made more money selling puts today, but their invested capital/collateral is zero, meaning as long as stocks don't stay low for 20 years whatever profit they make will equal an infinite ROIC.

2008 Nov 26 02:05 AM

[sumosama:]

FS, you are really too much. When someone actually trusts you to manage billions of dollars, THEN and only THEN will your thoughts be relevant. This, as well as the other investments recently made by WB, are strokes of genius meant to bring in returns long after he goes on to his final reward. Sheesh!

2008 Nov 26 12:25 PM

[Urbane Gori...:]

I don;t pay a lot of attention to Warren Buffet, except I do like his pithy attitude. But, I did listen vaguely to someone explain the Put issue on Fast Money last night. Apparently the guy is a Warren Expert. He said that the puts raked in some amazing amount of money ($5 Billion?????? ) and that the value of the puts barely exceeds the worth of Berkshire. Normally that would be scary. He said that the Puts were insurance bought by some life insurance or annuity company, in the event that they could not fund their obligations in the future due to a drop in the market. The guy said that for Berkshire to lose the full value of the Puts, the market would have to drop to zero. The Puts are time out in 20 years. In the full history of the market, there has never been a 20 year period with less than a 1% return. He noted that Buffet know and is in the insurance business. In essence, the Puts provided a lot of immediate cash, with an infinitesimal risk.

Disclosure: I'm not a Buffet or Berkshire fan.

jegan

2008 Nov 26 02:56 PM

[Erich Riese...:]

I would like to give you $1, so that you too can experience the joy of an infinite ROIC.

Could you return the favor? Thank you.


On Nov 26 02:05 AM najdorf wrote:

> Alex: As has been discussed many times, they're European-style puts,
> exercisable only as expiration. The whole point of the investment
> was that the length of the option prevented any short-term market
> risks. BRK has sold someone an insurance policy against long-term
> stock market depreciation. As always, the company continues to operate
> as a moderately bullish long-term stock-market investor that attempts
> to take short-term volatiiity or risk in order for long-term profits
> in excess of what it will have to pay out in insurance.
>
> Of course BRK could have made more money selling puts today, but
> their invested capital/collateral is zero, meaning as long as stocks
> don't stay low for 20 years whatever profit they make will equal
> an infinite ROIC.

2008 Nov 27 08:42 AM

[cellardoor1:]

"It'll be interesting to see how the details of how Buffett values the put in his next annual report. Although Berkshire's CDS spreads make the put worth only $5 billion to the hedger, it's still a $10 billion liability to Buffett, at today's volatility levels."

If your reference to liability is made in the accounting sense, you're sort of correct.*

However, in the economic sense, I don't see how you can separate these issues** -- after all, the mark-to-market value of these puts _has_ to take into account the huge embedded exposure to BRK credit risk. If BRK blows up, the maximum value of these puts is whatever collateral BRK had to put up -- and that's not much, even in a drawn out, gradual downgrade-type situation.

*-Kind of like how GM's bonds may have to show up on their books at par, even if they're trading in the market at cents on the dollar (and in theory, GM could go out and buy them in the open market at that level and retire them)

**-I'd maybe agree with the general principle that CDS markets are more illiquid/more likely to be distorted, etc

2008 Dec 04 11:05 PM