Berkshire Hathaway: Worst Year Ever, and CDS Too

Warren Buffett has out his annual Berkshire letter, and you will find lots of close line-reading at all the usual places. My takeaway -- beyond the obvious that this was a horrible year for Buffet, the worst in his career -- come from the derivatives section toward the end of the letter.

In short, Buffett continues to explain why, as an ardent critic of derivatives, he has a significant position in same. He has written put option on various equity indices around the world, essentially a bet that market will be much higher. These bets, while paying premiums, are current badly underwater. At the same time, he says in his letter that in 2008 he, for the first time, wrote some credit default swaps. That is a fairly remarkable admission given his public views on the subject.

Considering the ruin [of derivatives that] I’ve pictured, you may wonder why Berkshire is a party to 251 derivatives contracts (other than those used for operational purposes at MidAmerican and the few left over at Gen Re). The answer is simple: I believe each contract we own was mispriced at inception, sometimes dramatically so. I both initiated these positions and monitor them, a set of responsibilities consistent with my belief that the CEO of any large financial organization must be the Chief Risk Officer as well. If we lose money on our derivatives, it will be my fault. [Emphasis mine]

The line I have highlighted above is quite the hubristic admission. Read the whole thing.

Comments

[bigmoney:]

>> I believe each contract we own was mispriced at inception, sometimes dramatically so

I am sure they were mispriced ... too high. I wonder if Buffet will get a government bailout. Get that BRK-A back above its 200 ma.

Feb 28 10:01 PM

[Nik Kondrat...:]

Is anybody really that surprised by BRK.A's performance? Buffett was publicly declaring his faith in US equities, so I'm not that shocked to see he had his worst year. But what really sticks out as incongruous is his public position against CDS and derivative products while privately taking those bets. I think it proves the point those products were just so enticing even the best and brightest couldn't resist.

Feb 28 10:18 PM

[PROXIMO:]

My hunch is that Buffett's initial use of derivatives was for balancing the risk factor in some of his insurance operations. Once he started, the derivatives were his fix. Notice that despite losing his ass for the world to see, he makes no mention of discontinuing the derivatives use. Like a crackhead with a vial or a heroin addict with a needle. He keeps it up and you'll be able to buy Berkshire stock for a discount at your neighborhood yard sale or pawn shop. Every buy-and-hold investment advisor in the past 15 years who openly bragged about being a "Buffett style" investor should be sentenced to the crackhouse also, to ponder the inherent uselessness of value investing, epecially with regard to how full disclosure on financial statements is discouraged (SEC, Enron, Madoff,Worldcom, Stanford, crooked auditors etc.).

Feb 28 10:19 PM

[Ricard:]

I don't believe these contracts are related to CDSs. I think he's referring to the equity puts he wrote. The mis-pricing he mentions here correlates to his argument in the letter that Black-Scholes valuation methods tend to overvalue such contracts - his explanation of this begins on pg. 20.

The notional value of the derivatives (puts) is around $37 billion, far lower than BRKA's cash on hand. Compare that to any of the financial institutions at risk of default, and you'll find it to be a very low amount indeed. Citigroup has $32 TRILLION.

Feb 28 10:29 PM

[1worldcurrency:]

Down 44%. Good thing the taxpayer bailed Warren Buffett out with billions in TARP money to WFC, AXP, GS....

Feb 28 10:36 PM

[HiSpeed:]

WOW!

Buffy is writing Credit Default Swaps! For those with short memories it's this very action that blew AIG and BSC et al out of the water.

As I recall Buffet loaded up on GE among other stocks just before the first TARP was passed - stating that he was betting on it passing and that if it did not, that he would have made some bad decisions. Well. Given that it DID pass and obviously was a classic definition of throwing good money after bad, and the market simultaneously tanking, I'd seriously question whether Mr Buffet is still the smartest guy in the room - sounds like he's losing it.

Feb 28 11:04 PM

[WMBANZAI7:]

THE ANSWER WARREN MY FRIEND, IS BLOWIN IN THE WIND
(Blowin in the Wind, Bob Dylan)
WilliamBanzai7

How many points must the DOW slide down
Before we can buy once again ?
Yes, n how many zombie banks must Uncle Sam bail
Before Federal budget disappears in the deficit sands?
Yes, n how many times must FWMD balls fly
Before they're forever banned?
The answer, Warren my friend, is blowin in the wind,
The answer is blowin in the wind.

How many times must an investor look up
Before he can see the Ponzi blue sky?
Yes, n how many ears must the SEC have
Before it can hear the whistle blowers's cry?
Yes, n how many financial disasters will it take till it knows
That too many greedy CEO's have lied?
The answer, Warren my friend, is blowin in the wind,
The answer is blowin in the wind.

How many years can a bloated asset bubble exist
Before its washed to the bear market sea?
Yes, n how many years can an self regulated market exist
Before it is consumed by Wall Street hubris and greed?
Yes, n how many times can a man turn his 401(k) head,
Pretending he just doesnt see?
The answer, Warren my friend, is blowin in the wind,
The answer is blowin in the wind.

Feb 28 11:13 PM

[KJP712:]

Great to see Buffett's legendary humor is still intact.Shareholder discounts for furniture purchases ? Hard to see how shareholders who lost half of their stock value will be in the mood to go pricing dining room sets and couches.Will be interesting to see how the shareholder meeting on May 2nd plays out.Will the once happy smiles of investors be replaced with frowns and scowls ? Or will the playful wrestling with the Geico Gecko have to be broken up by security guards as they mistake him for an angry shareholder ? The loss of 89% on the 2 Irish banks will cheer up other Investors who can point out that they lost less than Warren did last year.The letter represents a final exclamation point on a disastrous 2008.

Feb 28 11:34 PM

[ustaad:]

I'm not sure why Buffet initiating derivative positions is such a big deal. He's primarily a handicapper with years of experience. These contracts are not that much different in nature than the super cat insurance policies he takes out.

A chainsaw in a kids hand is dangerous but not so much in the hands of professional. The point he made re: derivates was proved right by AIG and others last year.

If Buffet is pooh poohed by the folks at Leucadia, it can make a little bit of sense given their respective track records over the last 20 years. One bad year seems to give everyone a license to second guess the man. Insane!!

Mar 01 12:18 AM

[waterlily57:]

No one has asked who is on the other side of the bet. My guess is that they are funds (pension funds?) who want to insure against down markets in future years. These funds do not mind paying the premium, hence underperforming in the short term, but get insurance at the maturity date. To me, Buffet is just engaging in the futures market of equities. Not really CDS in nature. Currently he possesses the float to invest in. As someone said above, it is like the supercat insurance.

I am not totally agreeable to his idea and I don't see the global economic value of the whole thing. Just like gambling? I believe he is not explicit because he doesn't want imitators to come in too fast, not that there are many who can mimick at this time.

Also, he says he is totally responsible for the whole thing. Well, if he is younger, then he'll have a high probability of being around in 2019 to own up to that responsibility. As it is it is possible it will be the company who will own up to that responsibility.

Mar 01 01:14 AM

[PenName Dave:]

I think Buffet is right... his PUTs expire in no earlier than 10 years from now... some 20 years from now. So even if the market doesn't recover, all he's done is borrowed money at a slightly high interest rate. If it does recover.. and we're talking about 10 to 20 years from now... he'll have gotten free money.

Mar 01 03:31 AM

[PenName Dave:]

To clarify.....

He sells the PUT for $100 now, and if the market goes to 0, he'll have to pay $400 in 2030. Seems like a huge loss for him, but if you factor in the fact that he gets to hold the $100 for 20 years.. you'll see in the worst case he's just borrowed 100 and will have to pay 400 in 20 years. As bad as that sounds, its just 10% interest... and thats if the markets goto 0.

Mar 01 03:34 AM

[waterlily57:]

Another thing is his operating model, if i may call it, is to use the insurance float to invest in equities. This postulates that the invested equities increase in value at a higher rate than the claims on insurance happening on long tail policies. This works well on property insurance. For example when a Katrina or an earthquake happens, the probability of that happening in a severe bear market is low. So he could sell a lot of stocks to pay for the claims, under that model.

Now, when you bet against the stock indices, you better not have a whole lot of reserves tied up in equities. Because you will get next to nothing by selling stocks to pay those claims. Maybe he will line up his reserves to include a lot of treasury bills, commodities, gold, etc when the derivatives are about to mature. Who knows?

Mar 01 04:19 AM