Berkshire Hathaway: Proof That the CDS Market Is Irrational 48 comments
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Markets at times are rational, efficient, information-processing mechanisms which correctly price asset markets.
And at other times, the market is an idiot.
This struck me - as it does every day looking at my screens - reading this article from Bloomberg.
Warren Buffett's Berkshire Hathaway Inc. and Jeffrey Immelt's General Electric Co. are being battered in the market for credit-default swaps, treating both AAA companies like junk.
Let's put aside GE for a moment, because I think there is some legitimate debate regarding this company. But Berkshire Hathaway a junk credit?
Investors are paying as much for contracts that protect against a default on the bonds of Omaha, Nebraska-based Berkshire, which has $25.5 billion in cash, as for KB Home, the homebuilder that lost money for seven consecutive quarters. The cost of credit-default swaps on the finance arm of GE and its $45 billion in cash is about the same as for building materials- maker Louisiana-Pacific Corp., which posted nine straight quarterly losses. ...
Swaps on Berkshire have soared 2.26 percentage points the past two weeks to 5.35 percent a year, CMA data show. That compares with 4.9 percent annually for Los Angeles-based KB Home.
Berkshire and KB Home (KBH) priced the same in the credit default swap (CDS) market? Tell me that the market isn't completely nuts right now.
Now, full disclosure: for the first time ever, I purchased Berkshire shares last week. But I would be writing this article even had I not.
There are three issues with Berkshire I see that could spook the market. The first is that the company writes CDS swaps on corporate debt. What is Berkshire's total exposure?
Berkshire in 2008 started writing credit-default swaps on individual companies, with contracts guaranteeing $4 billion of debt from 42 borrowers, Buffett said in the letter.
In other words, if every single borrower whose debt Berkshire insured went under, instead of $25 billion in cash, Berkshire would have $21 billion. Berkshire does not need to post collateral on its CDS positions, so there is no threat of a financial company death spiral, as I explain below.
The next issue are the puts Buffett sold on the market.
Buffett has struck deals with firms that Berkshire hasn’t identified to protect them against declines in four equity indexes and guarantees on indexes of non-investment grade debtors that require the company to pay out when there’s a default.
The derivatives that garner the most attention are the ones Buffett wrote on stocks. However, those options are European options, meaning they can only be put back to Berkshire when they expire, which they do in a decade. So there is no cash liability for Berkshire until that time. Any market-down on Berkshire's books is an accounting one, not an economic one.
Finally, there is the issue of insuring municipalities. States and municipalities are in a great deal of trouble. However, Berkshire entered this market within the past year, and would barely put a dent into the company's cash pile if all the contracts - which are often second and third behind other bond insurers - had to pay out, i.e. if all the municipalities failed.
Near as I can tell, Berkshire has not sold any variable annuities which are hammering the likes of Hartford Financial (HIG). Berkshire's insurance risks are primarily the non-financial kind. Have there been any massive earthquakes or hurricanes the past few weeks that I am not aware of?
The playbook for collapse for many financial companies has been underwrite CDS, not post enough collateral, bond spreads widen, CDS liabilities rise, CDS prices rise, underwriter's stock falls, spreads widen further, liabilities rise more, CDS prices rise further, underwriter's stock falls further, market gets fearful that the underwriter will have to issue more equity, stock falls further, CDS prices rise (sometimes with no spread widening of the issuer), ratings agency downgrades debt because of rising CDS liabilities and falling stock price, underwriter must post more collateral, underwriter's stock falls even further making it even more difficult to raise stock, ratings agencies downgrade debt again requiring more collateral be posted, and so on until the stock price has collapsed that it becomes virtually impossible to raise common share capital from private interests. There is great interest in breaking stocks through this process.
Now, that is not to say that many firms did not deserve to go under. Companies such as Bear Stearns, Lehman, AIG (AIG), Countrywide, and many, many others were extraordinarily stupid, and set their fate, even without any help from the derivatives market.
However, this downward spiral of fear can feed on itself.
A lot of traders “are in a position of where it’s sort of hedge or lose your job,” Backshall said. When GE credit swaps soared to as high as 20 percent upfront yesterday, “that was likely driven just by a desk deciding to desperately hedge,” he said, “rather than a real belief” that the company had a high risk of defaulting.
This is George Soros's theory of reflexivity, where a negative loop feeds on itself and the perception becomes reality.
This occurred during The Great Depression. A study by an economist at the Federal Reserve found that banks which failed during the Depression were often as financially strong or stronger than banks that did not. This, of course, runs counter to classical economic theory which postulates that investors and depositors are rational economic agents. Rather than processing information in a rational manner, people became scared and pulled their money out of banks, regardless of the bank's financial health.
This is what I believe is occurring now. All deposit-taking institutions and most financial companies are being taken out and shot, regardless of their intrinsic health. Financial companies especially are prone to this irrational reality since they are highly levered institutions and can easily fail.
The CDS market, which is fairly illiquid, facilitates and enhances this process. It too can be irrational. For example, there has been a disconnect in the high-yield market as prices in the cash market were up this year while prices in the derivatives market were down. The difference in return has been 15% in two months. That is enormous. And ridiculous!
Markets can act irrationally. I believe they are now. Always using a market, any market including the derivatives market, as an accurate gauge of financial and economic health is folly as the perception of the market can become the reality itself.
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This article has 48 comments:
"Markets can act irrationally. I believe they are now. Always using a
market, any market including the derivatives market, as an accurate gauge of financial and economic health is folly as the perception of the market can become the reality itself."
This quote is very interesting. While I wholeheartedly agree with this statement, I can say that most of America doesn't, especially any baby-boomers approaching retirement. For many people, the various markets are the embodiment of their net worth, and dramatically affect their habits. Many people will see their 401Ks shrink, and pull out before experiencing further losses, and by doing so, uphold Soros's theory which you point out (very nice, BTW - first time I've seen reflexivity used in analysis).
Most people are not disciplined investors. While most people on this website may appreciate your words of wisdom, I fear for those who do not.
The trade is very rational and doesn't take very long to become profitable. In a short time both postions become profitable as more traders pile on.
Example:
1. Bank XYZ is healthy, all others are not
2. Depositors take all there money out of all the banks, including XYZ
3. You don't, because you know XYZ is healthy
4. All banks fail and you lose your money because you were being rational
5. The irrational people who pulled their money out early got to keep it
So the irrational end up being the rational, and the rational, irrational.
I hope this makes sense, otherwise you will lose all your money trying to change the world.
> Who lends out shares of BRK.A for shorting?
As with any other stock, the brokers who are custodians of the shares for their clients. This is not a new notion; Doug Kass was short BRK for several months last year.
Short the company with high volume daily transactions to the hilt.
Buy CDS of the company with very thin market volume thus needing only small capital to jack up the price.
Presto, everybody saw CDS climbing and the company might be in big trouble. At the rate things do happen these days, you better shoot first and ask questions later. Hence, traders and investors will have to hedge their positons and company shares goes down in a hurry and nobody can stop it even government intervention due to the sheer volume being traded on the company's common.
Goodbye GE, goodby BAC.
Why not use the power of CDS to take Berkshire down? Shorting beaten down stocks do no produce too much profit anyway. Shoot those big fat birds fying high.
I'm no good with CDS thing but that is how I'm starting to understand the positive (or negative) feedback of the CDS market to the equity markets.
Is this Terrorist Scenario possible and how easy would it be to execute such scenairo?
ECONOMIC TERRORIST: Let us destroy those companies that are essential to the US economic survival. A few hundred millions of capital might be enough in order to bring down that giant into it's knees. We will only have to learn how to use CDS to destroy those companies. Once we succeed with one small prey, we will make a lot of money and we can do it over and over again until we can do it with the biggest companies.
Will the unregulated CDS market need to be investigated, regulated, and controlled if necessary in order to prevent such a scenario?
If Buffet dropped dead tommorrow, my guess is the shares would drop off a cliff. If the financial markets grind to a halt, and noone can even discount this, Holding BH could prove very very painfull.
I would guess MassMutual, New York Life, Prudential, and Northwestern Mutual.
2. Short sellers have completely vindicated themselves in these markets; they are the ones that have been right. Even Chris Cox finally officially admitted – banning short selling was the worst decision of his tenure – markets fell the most during that period. Short selling ban has since been revoked – markets continue to fall but at a lower and more orderly pace.
3. Buffet/CDS: Hard to say what the situation is with BRK. He has made bad bets – derivatives, selling S&P puts. Again boils down to lack of transparency – there I is no disclosure about these puts – at what level of S&P they have been written. All we hear are vague things – European style puts, decade duration, etc etc. There are people who find it easy (and cheap) to assume the worst. Right now he has booked a mark-to-market loss of $6.9B. GE CDSs are trading very high - any takers of GE - likely not.
4. All of Buffets financial holdings may be under water, if AXP goes to 9 (it very certainly will shortly) – even that would be under water. So he may lose a lot , 60-70% of his life time earnings in this episode. It is anyone’s guess where markets would go next.
So yes CDSs may be quite right – time will tell.
How to Make a Killing Shorting Berkshire Hathaway Stock
www.associatedcontent....
The Penny King Laughing All the Way to the Bank of Pen
www.associatedcontent....
Will the unregulated CDS market need to be investigated, regulated, and controlled if necessary in order to prevent such a scenario?<<
aarc,
You've really hit the nail on the head. I can't believe we are still allowing this ludicrous, highly damaging, company-wrecking game to continue. It is definitely in the realm of "financial terrorism" if you ask me - and so are a number of other loosely-regulated and quite nefarious practices on Wall Street.
I believe that we should see action very soon to reign in this garbage, or just shut it down altogether. If we had better people running the Fed, instead of a bunch of chalkboard economists who are all in awe of and bought off by the Wall Street colossus, we would have shut this crap down several years ago.
That might have saved the honest citizens of the USA a trillion or so; now they are being held up at virtual gunpoint by the minions of the banking sleaze machine.
It's time to hold the Federal Reserve accountable for the swindles in which it actively participates.
Remember: its the traders that are keeping this free market capitalist society together NOT GOVERNMENT! You need to treat BRK.A and BRk.B stock just like any other stock. We have the right in a capitalist free market to bet on value of stock going up just as much as betting on the value of it going down!!
Don't blame short sellers for driving the markets down!! Blame Obama, Geithner, Congress,for there policies that are actually acting against the markets. Its ridiculous actually because most Americans have there 401Ks and IRA's in the stock market. This president has destroyed more wealth than any other president in such a short period of time because he will raise taxes. You don't raise taxes during a recession. It will only prolong it.......
The oil market behaved irrationally too because of manipulation.
What can you say to the insane are in charge of asylum to change their minds..
Wall Street is totally focused on "ME" and will NEVER think about the consequences it creates on normal family life.
CDS's are viable financial tool but they needed regulation to contain them and without meaningful rating system and boundaries, they became instruments of looting the public.
On Mar 07 11:49 AM China Expert wrote:
> The CDS market is one of the major culprits that threatens our financial
> system
The average invester is nuts because they listen to bankrup banks and Cramer's advice.
Daniel Kowkabany
Instead of the point you are making, I'd change your example a bit by using equities instead of bank deposits, and replace your quote with the saying "the market can be irrational longer than you can remain solvent". However, if you did not utilize margin to make this investment, you should be fine. This is the core premise of value investing.
On Mar 06 10:08 PM mrbill wrote:
> It is rational to be irrational if you believe that it will save
> or make you money.
>
> Example:
>
> 1. Bank XYZ is healthy, all others are not
>
> 2. Depositors take all there money out of all the banks, including
> XYZ
>
> 3. You don't, because you know XYZ is healthy
>
> 4. All banks fail and you lose your money because you were being
> rational
>
> 5. The irrational people who pulled their money out early got to
> keep it
>
> So the irrational end up being the rational, and the rational, irrational.
>
>
> I hope this makes sense, otherwise you will lose all your money trying
> to change the world.
Conversely: If, as an insurer, the majority of your holdings require you to insure the debt with credit default swaps you are, by definition, "irresponsible".
Merely buying worthless paper to cover loss is not prudent.
Mr. Lanthrop, hedge funds are not buying CDSs to hedge against bond portfolios. They buy them at the same time they are shorting common. They do this to incite fear in the markets. Last I checked market manipulation was supposed to be illegal. If the SEC was doing its job, these things would have been made illegal over a year ago.
I have no problem allowing anyone to short a stock. An argument against CDSs is not an argument against shorting. But we cannot allow someone to link a short position with a CDS to manipulate markets.
We need to get our financial markets back to the basics of buying and selling stocks and bonds. Its the derivatives that are destroying us.
Sure, it has a great position in the insurance markets and has generally stayed away from more risky underwritings but the value of its float has declined with rates of return and it could be on the hook for big payments in the future.
The puts are very problematic. A repeat of the '29 depression with flat stock prices will result in a sizeable payout on the sold puts.
It's businesses should decline in value along with the broader market. I believe purchase multiples have already declined 33% and will likely fall further. A 12x EBITDA valuation on this portfolio is unreasonable at best.
I respect Buffet but his reputation does not make him immune to reality.
On Mar 06 10:08 PM mrbill wrote:
> It is rational to be irrational if you believe that it will save
> or make you money.
>
> Example:
>
> 1. Bank XYZ is healthy, all others are not
>
> 2. Depositors take all there money out of all the banks, including
> XYZ
>
> 3. You don't, because you know XYZ is healthy
>
> 4. All banks fail and you lose your money because you were being
> rational
>
> 5. The irrational people who pulled their money out early got to
> keep it
>
> So the irrational end up being the rational, and the rational, irrational.
>
>
> I hope this makes sense, otherwise you will lose all your money trying
> to change the world.
Recent finanical crisis are leading me to believe in the following: a financial transaction is reasonable as long as it can be handled by common public. If you can imagine implementing in a small village with people understanding it fully, it may be a good financial idea.
CDS don't seem that way. They may look like innovative ideas initially, but in general, they seem like financial tricks.
Technically, you are correct in saying that hedge funds are not holding the underlying bonds and are merely speculating in their purchase.
Technically, Ned Flanders of The Simpsons was correct in saying that he did not believe in insurance because it was a form of gambling.
I assume you have insurance on your house and that you are not above protecting your assets. In fact, if you own a car, chances are your state requires you hold these gambling contracts to prevent against losses, also known as accidents.
But you still have not answered how these alleged hedge funds are using CDS to drive down the prices of companies who have lots of cash and little debt.
But Berkshire has cash! you exclaim. Not really. They have float, which is to say, premiums which are supposed to pay off future claims, a gamble in themselves. Essentially, Berkshire Hathaway takes other people's premium and hopes to invest them in a way that would realize a profit over and above their risk models for possible claim payouts. This is different than ExxonMobil's or Pfizer's money which was made selling actual profits. Yes, that big furniture warehouse in Omaha is impressive but its not representative of the company - in fact, that and the other wonderful quirky little companies that Buffett collects like Beanie Babies are profitable but not enough to justify that share price.
So we have a company who took policyholder's premiums and invested them in ConocoPhillips when it was trading at 85 dollars a share among other trigger-happy decsions which wiped out all the unrealized gains of careful investing. The CDS prices realize that and instead of speaking about the fundamentals of the company, you just rail against speculating and short selling, just like Cramer cries about SKF every night, telegraphing to the nation that his holdings in his Fortress Banks are going to zero.
We would all be better off if instead of railing against an invisible entity, you just sell. I bought a share of BRK.B at 4950 and when it fell to 3600 that was enough *value* for me thank you very much. A ridiculous share price for a stock that doesn't even give a dividend, and now you know why they don't give a dividend, because he'd rather spend the money on European style derivative contracts which can't be cancelled until the due date. This is coming from Mr. Derivatives Are Weapons Of Mass Destruction Unless I Use Them And Then Its Okay.
Finally, if you take the time to read The Snowball, like I did last month, you'd notice the similarities between Buffett's investing mystique - the inside information, the canny timing and the opaque methods - as Bernard Madoff. I am not saying Mr. Buffett is running a Ponzi scheme but investors are tired of the folksy wisdom on the one hand and the murky accounting on the other.
> Well it seems logical to me, the CDS's. Revenue for BH is down 96%,
No, profit for the 4th quarter fell 96% from the previous year, driven by mostly non-cash investment losses. Revenue fell 12%. OPERATING profit rose 43% to $3,370,000,000. Extend this to a full year, and it puts the P/E for the company at about 9.
> the company has entered into shadowy CDS's and derivative bets...
Ooooooh, shadowy - sounds so scary. Did you even read Buffett's letter?
>, Buffet is not getting any younger, and he admits he has made some "dumb"
> investments.
Hey! You got two things right. You're a genius.
> On top of this the shares seem dramatically overpriced
Dramatically overpriced on what basis? Book value, where it's now trading right about at book? Tangible book value, where it's at about 1.4x? Operating cash flow, where it's priced about 10x? "Dramatically overpriced"?
> and they are near impossible to short due to low volume trading.
Hogwash. How does low volume inhibit shorting? It's actually the opposite, as shares are less likely to be called back because the owner wants to sell. If it's so hard, how was Doug Kass able to do it last year?
> If Buffet dropped dead tommorrow, my guess is the shares would drop
> off a cliff.
And it would be the buying opportunity of a lifetime.
> If the financial markets grind to a halt, and noone
> can even discount this, Holding BH could prove very very painfull.
Why? Because Berkshire would be able to continue to extract absurd premiums for lending, as it's done recently with Harley-Davidson for example?
Thank you for all the softball opportunities to correct you.
Just because Buffet has a good name doesn't immunize him from the derivatives blow-up. If you play, you pay.
Berkshire entered the CDS market too early.And it's portfolio is poor perform.
The stock price may fall to $50,000.
On Mar 07 07:52 AM Alex S. Gabor wrote:
> Here are two recent articles that might explain why BRK A and BRK
> B are the greatest shorting opportunities of the Century:
>
> How to Make a Killing Shorting Berkshire Hathaway Stock
>
> www.associatedcontent....;cat=3
>
>
> The Penny King Laughing All the Way to the Bank of Pen
>
> www.associatedcontent....;cat=54
Over the past year+, every step downwards in pricing has been accompanied by bottom calls and inflows from value investors (private equity, Buffett's buys, foreign investment in C/MS, equity offering from GE & WFC, etc.). The fact that companies have continued to move downwards each time is due to very real problems in our economy and within these companies. On the back end some companies will survive and rise quickly in price, but more may still fail. At the start of this crisis people were saying things like "Sure WB and WM have problems, but C and BAC can NEVER fail; it's a sure double from current prices (~20 and ~35) if you can hold for 5 years". Does anyone still want to ride that train?
Investors may have become irrationally fearful about some companies (look at current pricing on MSFT/JNJ/T/VZ/etc - not as exciting as the banks but hard to imagine negative returns or returns inferior to treasuries for much longer) - but there are real reasons to be fearful about banks. People were scared to invest in banks long before anyone concieved of CDSs; the US had regular financial crises in any economic downturn for the first 150 years of its history. One of the major causes of this crisis was that we forgot that fear of banks after the success of reforms like FDIC and the relative lack of pain for large US banks in the S&L bailout/early 90s recession.
Folksy is right. I have seen WB quoted so much, the adulation is palpable. Puts and CDS. Whatever is he thinking? I think his empire is in shambles. It will surely take some acumen for him to recover. The shares I hold in B are actually junk. I don't expect them to ever be worth much again. Seems like in his dotage he just got tired of just plain old investing wisely and so he decided to take a flyer and live on the edge and dangerously. I could have recommended sky diving or bunge jumping. Anything but these ill-advised forays into exotic strategies. Get hold of yourself, Warren!
It's amusing to watch posters who've only learned of credit default swaps in the past few months now militating for the government shutting them down. I presume they wouldn't seek to ban homeowners' insurance simply because premiums took off. What WOULD happen in the event of shutting down the CDS market is an immediate rise in the yields in the bonds of the issuing companies, as well as municipal governments. If you can't protect your fixed-income investment against default risk, you'll demand substantially higher yields. And higher yields raise the cost of capital to these companies, increasing the likelihood of their default.
The Law of Unintended Consequences, and all that. Be careful what you ask for. Maybe if BRK CDS premiums are spiking, the market is trying to tell you something that merely doing away with CDS's isn't likely to fix.
On Mar 07 06:19 PM korba wrote:
> I don't have a complete undestanding of CDS. But, from the comments
> here, I sense that most people, not deeply involved in financials,
> are having a tough time understanding this. I treat this is as a
> negative for CDS.
>
> Recent finanical crisis are leading me to believe in the following:
> a financial transaction is reasonable as long as it can be handled
> by common public. If you can imagine implementing in a small village
> with people understanding it fully, it may be a good financial idea.
>
>
> CDS don't seem that way. They may look like innovative ideas initially,
> but in general, they seem like financial tricks.
On Mar 08 08:39 AM Jimmy Lathrop wrote:
A heavy volume of CDS bets
> against a company doesn't drive the share price down, poor performance
> of a company drives a stock down. Don't start crying about how CDS
> killed the mega-banks, we all know they are actually insolvent and
> it is only through accounting sleigh of hand and politicians needs
> for jobs post-office that keep them lurching forward.
Anybody can buy an insurance on anything they do not own. Anybody can buy insurance on any company they do not own at any amount over and above the value of that company. Nobody is going to inquire nor investigate. It is a wild wild west out there.
For example: I can buy CDSs for GE at 10x the value of GE without me owning any stock of GE. Therefore, I will be insuring something I do not own. If GE goes bankcrupt I make a lot of money. Likewise, if I short GE common stock to the hilt in just one day with sufficient capital; it will tank in one day and traders and investors are going to take notice. They will look at the CDS and they will see CDS premium going up (due to my buying spree of CDS) and fear will become the dominant factor. As for me, I can always protect my short positions with stop loss limit and thus will only incur minimal loses.
When fear dominates, logic goes out of the window, investors will be shooting first and asking questions later - they will be selling whatever they can afford to sell to mitigate the unknown or buy as much put options as they can afford. Likewise, traders will be shorting the common stock with gusto knowing very well how to take advantage of investors' fear and panic.
Once the company stock price has gone down drastically, it's tangible book value will deteriorate rapidly and hence the once healthy company becomes insolvent in a very short period of time and will most likely be headed for bankcrupcy. It can happen in a matter of days or weeks.
Question is; how could a viable company suddenly become insolvent in a matter of days or weeks with no radical changes in it's management, it's sales and profit, it's expenses, etc? How could it become insolvent when there was no radical change in the country or the whole world in general?
Do you call this free market forces or can you call this manipulation of free markets?
How could it be that you can insure something you do not own in the first place?
It is like insuring somebody for 1 million dollars and then killing and making additional money robbing that person in order to be able to collect the insurance without breaking any law at all in this wild wild west environment of CDS.