Buffett Closes Derivatives Contracts, Goes Back to Writing Insurance

Omaha, NB - "In a surprise move, Warren Buffett has replaced the much-maligned derivatives contracts he wrote last year, with insurance policies written on a variety of equity indexes. Doug Kass, who has been one of the most vocal critics of said derivatives (European put options that Buffett wrote on a variety of equity indices) declared that his accusations of "style drift" have been vindicated by Buffett's surprise move. Now, instead of receiving a premium up front in return for assuming a risk that said indices decline to levels below 2008 levels by the end date of the contracts 15-20 years from now, Buffett has now received a premium up front in return for assuming a risk that said indices decline to levels below 2008 levels by the end date of the..." Hey... wait a minute!

Get the point (Doug)? Buffett's short puts are nothing new for him, and do not represent style drift. They are simply insurance policies that Buffett was willing to write in return for $4.9B received up front. Much like an insurance risk, Buffett knows his maximum loss, and knows how much in premium he will receive. Even better than an insurance policy, he knows the date of any potential liability.

Buffett is all about float, and these puts are no different. He has $4.9B to play with for 15-20 years. His maximum loss, assuming all stock indices go to zero, is $37.1B, 15-20 years from now. Now, somehow, I think if all the indices are worth zero in 15-20 years, we will all have much bigger problems (like wishing we had spent more time studying the Mad Max movies for survival tips).

Let's do the exercise anyway. I am just going to assume a 37.1B liability in 17.5 years. Present value at 3% inflation (3% - yeah right!)? $18.7B. Subtract the $4.9B premium, and you get $13.8B. That's a lot, but Buffett can afford it. We did forget to multiply that scenario - which I tend to think is a wee bit unlikely - by a probability. What is the probability that all the indices are worth in 15-20 years? 50%? Then you better start Mad-Max-ing. How about 26%? A 2.6 in 10 chance? Not likely either, but let's use it (because the math works). Then the expected value is -0-. Any lower probability than that (which anyone except maybe Roubini would undoubtedly assign that scenario) and the expected value is positive!

Or, we can flip it around. Again, Buffett has $4.9B in cold, hard float today. We have already seen that Buffett can easily loan cold hard float to quality companies at a 10-15% coupon. Let's haircut that though and say he can only earn 6%. His 4.9B will magically float its way up to $16B. To lose that much on the puts in 15-20 years from now, the equity indices will have to be at levels 43% below those when the contracts were written. Not impossible, but certainly not likely.

We can play around with these scenarios all day. Well guess what - I'm sure Buffett and Ajit Jain "played" for much longer, and are more than fully aware of the risks. They do this stuff all day in the insurance markets with much more difficult-to-quantify risks. And their long term record, as measured by their combined ratio of <100 (i.e., they have been paid to play with other people's money), has been stellar. As Buffett wrote in his recently released letter, "Ajit's business features very large transactions, incredible speed of execution and a willingness to quote on policies that leave others scratching their heads."

When writing these puts, Buffett was doing nothing more than taking advantage of a "hard market" in stock market insurance. "Hard market" in the insurance biz means hefty premiums. As Buffett outlines in his annual letter, "stock market insurance premiums" are determined by the Black-Scholes model, which is heavily influenced by recent market volatility trends. So if the market is very volatile, you'll get paid much more to write insurance on it - even if you know that the possible payout is decades away. This is somewhat akin to a natural disaster causing insurance premiums to rise, even though a recent disaster may imply nothing new about the likelihood of a future disaster. Recent market volatility, although huge, may imply nothing new about long term market volatility, and thus implies nothing new about the far-future probability of a market disaster (and hence a payout by Berkshire (BRK.A) (BRK.B) on the puts).

Sure, one mildly unpleasant by-product of these market insurance contracts (short puts) is that unlike standard insurance contracts, they must be marked to market quarterly. Once again, the "mark" is determined by Black-Scholes for lack of a better method. At present, these contracts show a huge non-cash accounting loss. Who cares? No more cash will change hands until 2025 and beyond. Yet each quarter, Berkshire must take an accounting loss or gain based on what Black-Scholes "thinks" the present value of the contracts are. These marks should be of little concern to Berkshire investors, since they are simply a "guess" about the puts' value which will not truly be known for decades, and little if any collateral is required of Berkshire against the marks in the meantime.

Style drift? Bunk! My prediction: Buffett will make Berkshire shareholders billions with these "market insurance policies" - we just won't know for sure for a long time, and he may not be around to see them expire worthless. In the meantime, we can watch the $4.9B grow.

Disclosure: Long BRK.B

Comments

[Heaven, Hel...:]

Interesting article. Call it whatever you will, but at the end of the day Buffet is essentially selling long-term volatility and marking-to-model the value of the short illiquid European option. The $4.9 bn upfront payment represents the option premium and the payout profile is asymmetrical. A rose is a rose by any other name........or, depending on your point of view, you can't polish a you-know-what.

Just one minor point of interest/clarification... under the 6% loan scenario, the future value must be weighted by the probability of default and associated loss given default over the term of the loans -- no small haircut at this juncture given the current and projected credit environment coupled with the long-term nature of the financing.

Mar 04 12:49 PM

[dlaw:]

Yeah, people know how options work, particularly people who buy and sell stocks. They also know how float works. That's why Berkshire is down today.

The problem is that Buffett isn't making money from the float. He's investing in the wrong things. He hasn't lent money. He has bought equity in companies, making himself a junior creditor at companies, some of which are in danger of going out of business altogether.

On top of that, rather than placing a bet the market isn't aware of and can't bet against - like a *real* insurance policy - he has placed a huge, very public bet. This means that options players - particularly those who took the other side - will skew the public markets against him.

Let's look at the other side of the trade: those players paied $4.9 billion and now, unlike Buffett, have a huge assett on their balance sheet. Since they are probably leveraged institutions, that asset is saving them from having to borrow money. Relieving the burden of debt is the surest and most-profitable use of money there is.

Buffett figured that the knock-down to his balance sheet would cost him nothing, therefore they were mispricing the benefit relative to him. He wouldn't need to borrow under any circumstances. And yet there he is, whining in his letter about how it's so expensive for him to borrow money.

And, Buffett completely blew the volatility calculation.

So my question would be: which calculation did he even get right on that trade?

Mar 04 02:39 PM

[Dan O'Neill:]

Finally, someone wrote a good article. I was getting tired of Doug Kass's articles. The key differences Buffett made with his derivative contracts was that he got his premium upfront, wrote European options and does not need to post collateral (more than 1%) in the event of a ratings downgrade. The premium is float for the next 10 - 20 years. These options only have to be paid on the day of expiration. An American option has the potential to ruin a company in the short term, where a European option can only ruin a company at one point in time. We also know that the trouble that AIG and others got into was they had to post collateral if they were ever downgraded. Buffett does not have to post any material amount of collateral if Berkshire is downgraded. I'm a shareholder and I am comfortable with these derivative contracts. Warren and Ajit understand the risks involved and so do Berkshire Shareholders. They are making a well priced and well calculated bet.

Mar 04 03:09 PM

[jepittman:]

Its a good time to beat up on a buy-and-hold investor by traders. Rare opportunity in fact. Kass is a smart guy who knows a good thing when he sees it.

Interestingly Kass (a notorious short seller who obviously has done well) is now quite bullish. And not for a trade.

Mar 04 08:36 PM