Buffett Serving Free Lunch? (Part II) 20 comments
David Bailey
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Recently, I pointed out that the people who had taken the other side of Berkshire's (BRK.A) disastrous sale of index puts had already put the money into their pockets. The people who bought these options were clearly sophisticated traders and, via Andrew Clavell of Financial Crookery, Felix Salmon explains just how it's probably already been done.
Most readers got the idea that the money in those traders' pockets had to come from somewhere, but few accepted that – in some manner – that money had to come from Berkshire. The traders have put the cash in their pockets. Warren Buffett has only booked a “paper” loss. Again, unless the Buffett buffet serves an economic free lunch, the real cash gain and the paper loss have to come together somehow.
Some people suggested that “suckers” in the options market (many of whom have probably made a pretty penny since they bet) took the options off the hands of the happy traders because the options were “mispriced”. It's interesting how people who believe in the efficiency of markets suspend that belief when it comes to Warren Buffett. Apparently, the market always knows best, unless it's Daddy Buffett who knows best.
So let's look away from the CDS market and “gamma cross” hedging and speculate how else the market may take money quite directly out of Daddy's wallet:
Right now, the longest-dated, commonly-traded options are American-style 2017. Buffett's earliest are European-style 2019. But in the next year or so, 2019 options will come onto the market (big time) and we'll see that Buffett's was not a 12-year trade, but a 2-year trade. Once the 2019 strikes come on the market, some VERY interesting arbitrage opportunities present themselves, with some interesting consequences. We'll see that Buffett has created a very large, excess supply of profitable puts in the 2019 strike. And let's remember that Berkshire has not bet that the market will be higher every day in 2019, only on the days on which the options expire.
Presented with a badly-skewed market, traders will have to go long the underpriced puts and/or sell the calls. To lock in the arbitrage profit, they will have to go long the futures. This means, of course, that around the time Daddy Warren is expecting to collect his “buy and hold” profits from the spin of the big roulette wheel, we can expect some pretty vicious selling of the futures. Buffett and his Berkshire Bunch will find their purses and pockets picked of predicted profits and possibly – just possibly - a painful payment to pay, and not just on paper.
Losses on paper, Buffetteers will find, have very real consequences – sometimes even alliterative ones.
Warren Buffett has exhibited the fatal flaw in the “reversion trade” thinking he has come to represent. He has forgotten about liquidity risk and underpriced it in a cavalier, irresponsible fashion. Buffett's comparison between his derivatives trades and his catastrophe insurance business (page 16), shows the flaw in this thinking very clearly. The writing of catastrophe insurance has no significant effect on the occurrence of natural disasters. Financial trades are completely different.
Warren Buffett has forgotten that every trade in a market influences all other trades in that market. He's forgotten that in the financial markets he is not betting against nature or an “invisible hand” because there is no “invisible hand”. There is only the fractal product of many individual trades. Each trade, therefore, has a significant, irreducible, potential “Butterfly Effect” . The larger the trade, the larger the “butterfly” and thus the larger and more likely the potential effect.
$37 billion is a pretty big butterfly – like about the size of Mothra.
I want to echo Felix Salmon's conclusion when he says: “I don't think the equity puts come anywhere near to threatening the future of Berkshire Hathaway.” The company and its CEO have plenty of dough, goodness knows. Buffett's got so much money and controls so much more that Jim Cramer likes to say Warren Buffett is “the house”. But after the disasters in the averages and volatility, the odds have turned for Buffett in the derivatives market. In that casino, Berkshire is just another player and one to which the real “House” - the market – is giving terrible odds.
Can Buffett still win the bet? Sure. But if a generous casino's roulette wheel has a zero and a double-zero, and a cheap casino's roulette wheel has a triple-zero, right now Berkshire's index options bet is against a roulette wheel with something between a quadruple-zero and an octuple-zero. Whatever their faith in Warren Buffett's “system”, I think Berkshire's shareholders will find that the real House likes its odds just fine.
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This article has 20 comments:
The ultimate result will be a much better return than fixed income treasuries. Warren runs an insurance company, not a casino. He has smart people who have undoubtedly thought through a risk management strategy. Not surprisingly, the financial press has only reported a headline" and not explored further.
LordDarley
Liken it to your life insurance. It is there, you fund it, but you HOPE LIKE HELL you do not have to collect on it!
One simple possibility you seem to wholly ignore-- who says Berkshire has to sell these contracts at all? Why not simply let them expire and either pay (if the indexes are still below where they were when the contracts were written), or do nothing?
Thank you all for the comments.
All of the comments basically hit the same topic and I should have mentioned it in the piece.
First, those who say that Buffett can hedge haven't thought it through and don't know Buffett. The cost of hedging will be astronomical and easily wipe out any profits he might realize by holding to expiration and Warren Buffett is not really a guy who hedges (although his increase in CDS bets smack of a "double down"). His only saving grace in this thing is that he does buy and hold.
So Buffett really has to hold the options and suffer the consequences of failing to price liquidity risk. Remember how far away from the market these options will be. That's a huge inventory overhang in the out-of-the-money strikes. It will skew the options market for many years to come.
Uh... why do you think think Buffett's options are exchange traded? I'm pretty sure he wrote them on his own terms and they're not. Which means no excess supply of profitable puts in the 2019 strike which blows up your argument. But even if Buffett's options are exchange traded, I doubt it would be a large enough "butterfly" to push the entire US stock market down far enough for him to lose. As during the tech bubble, the calls for Buffett's demise are short sighted and premature. No offense but I'd bet on him over you until you surpass him on the Forbes list.
It's an indirect, probability-based effect, but it is a real effect.
These markets are all connected. Again, a one trade in the market affects ALL other trades. That's just the physics of it.
If I want to 100 shares of APPL, I can either 1) buy 100 shares today at, say, $100 for a total of $10,000, or 2) sell a January 2010 $100 put, for, say, $20 of premium per share.
In the event that APPL tanks to $50 tomorrow and stays there through 2010, I would have a paper loss of $5k doing #1, but only a $3k paper loss by doing #2.
Do you see the benefits of selling cash-secured puts on shares you really want to buy?
Buffett can hedge himself from that settlement day selling by shorting futures in advance
Bear markets always forget that economic growth is a GEOMETRIC mathematical function, with profits being leveraged to grow faster than GDP. Every single bear market in US history would have made an excellent buy-in point. This one is no different.
Critics of this like to point out that someone buying the Dow in 1929 would not have broken even for some 25 years (dividends notwithstanding). But 1929 was no bear market; quite the opposite.
We are 45% down from the peak, so this does not resemble buying in 1929. Also, the dividend yield in the 30's and 40's was excellent due to depressed equity prices and worth owning even without share appreciation. So is the dividend yield now. 3% yield of the indices might not seem like a lot, but given that fact that dividend payers tend to grow their dividends, that 3% can be an annual yield of easily 15+% on original principal a dozen years hence.
How many over Buffet's long and stellar career have critiized positions he had when they were underwater? Where are they now and where is he?
Would it be possible to explain in very basic terms how GS (or whoever holds these puts) actually turned them into cash? Do they (or the original buyers) still hold them? Clearly there is a potential for a cash gain, I just don't know how it is realized.
Sell puts very similar to the ones Berkshire sold but at the much-higher-price they would command in the market today, thus netting out the position. Their cash profit would be what they take in versus what they paid Berkshire.
They could use some of the money to buy calls or go long futures as well, thus profiting from the upside as well as the downside.
And they could buy CDS to hedge the risk that Berkshire won't be able to make good on the promised payment.
Noticed you ignored my question, so I'll state it again for you. What proof do you or anyone else have that the risk averse counterparties in this transaction are deciding to close their hedge and roll the dice going long...and on the long-shot that were true.....do you think that it might be a sign that the market had become grossly undervalued ....along with the puts.
Dudelaw....you are no different than the conspiracy theorists that run around wearing aluminum foil on their head. You are so convinced of some complicated master plan out there that you forget to look at the simplistic answer that is staring you right in the face.
On Dec 01 02:50 PM dlaw wrote:
> TomR - I'll leave it to experts to fill in the amounts, but I would
> say:
>
> Sell puts very similar to the ones Berkshire sold but at the much-higher-price
> they would command in the market today, thus netting out the position.
> Their cash profit would be what they take in versus what they paid
> Berkshire.
>
> They could use some of the money to buy calls or go long futures
> as well, thus profiting from the upside as well as the downside.
>
>
> And they could buy CDS to hedge the risk that Berkshire won't be
> able to make good on the promised payment.
>
Thank you for your interest.
I think you'll find it's not a case of conspiracy theory or anything else.
Some people bought some things (the puts) that have appreciated enormously in value. If these people are risk averse, as you suggest, then it's even more likely they will act to put the money in their pockets and invest it in safe instruments.
These are private transactions, so there is no direct evidence, but somebody has been buying a lot of Berkshire CDS. If Berkshire isn't going broke (and it isn't) why would someone do that? The most likely answer is what Mr. Clavell suggested - a hedge.
Thank you for your response. Now if I might...I'll logically refute it.
>>>Some people bought some things (the puts) that have appreciated enormously in value<<<
I totally agree with that statement.
>>>If these people are risk averse, as you suggest, then it's even more likely they will act to put the money in their pockets and invest it in safe instruments. <<<
You are missing an important point here. Buying the puts was a hedge for the counterparties....so why in the world would someone who is risk averse want to remove the hedge to "invest it in safe instruments"? They put the hedge on because they had large investments that they (or their regulators) didn't feel were all that safe, so by removing the hedge they would then be fully exposed to the risk of those investments....that doesn't sound very risk averse to me.
>>>These are private transactions, so there is no direct evidence, but somebody has been buying a lot of Berkshire CDS. <<<
Now we get down to the root of this delusional conspiracy theory that you've been brewing....the Berkshire CDS spike. You want another more plausible answer, look at the 11/23 WSJ article about the attack on Morgan Stanley and the effect on their default swaps.
The truth is that you have provided absolutely no facts or rational logic to support your far-fetched theories....as is usually the case with conspiracy theorists.