The other day CNBC's Dennis Kneale posed an interesting query of why AAA-rated Berkshire Hathway's (NYSE: BRK.A) credit default swap spreads ("CDS") were trading so wide, having risen from as little as 7bps in 2007 to an astounding 500+bps currently. After all, Berkshire's portfolio was down only 9.6% last year versus the S&P 500's 37% total return drop. Mr. Kneale logically concluded that this must be yet another "extreme situation" in the market. However, this is by no means a simple case of market misperception regarding Berkshire, as its exploding CDS spreads come as a direct result of its massive foray into equity index derivatives at the end of 2007.
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One can begin to unravel this mystery by examining Berkshire's various credit spreads. As one can see in the chart above, Berkshire's corporate debt spreads moved generally in line with USD AA-rated swap spreads during the course of 2007. However, this relationship began to break down in mid 2008, as Berkshire spreads rose to more than 200bps and briefly flirted with the 300bps level. Toward the end of 2008, its debt spreads came back down to 100bps level, yet remained well above AA-rated swap spreads.
Berkshire's credit picture was even more dislocated in the CDS market. After its 5-year CDS traded as low as 6.7bps in 2007, Berkshire's CDS spreads began to expand in line with the growing concerns in the credit market owing to the sub-prime mortgage crisis yet still finished 2007 at a still moderate 32bps. Prior to the Lehman Brothers bankruptcy, Berkshire's spreads had widened to 100bps, but then quickly shot up to over 300bps before peaking at 490bps in late November. Although its CDS spreads gradually fell back to the 300bps level toward the end of 2008, over the last two weeks they have notably widened again setting a new high of 525bps on March 5th for its five-year tenor.
Although multiple theories abound as to what is driving the dislocation of Berkshire credit spreads, the simple explanation results from its sale of $37.1 billion in notional value of long-dated (15-20 year) equity index put options on the S&P 500, the FTSE-100, Euro Stoxx 50 and the Nikkei 225 equity indices. The bulk of this transaction was executed at the end of 2007 to net Berkshire a total of $4.9 billion in option premium. Owing to steep drops in the equity markets, declines in long-term interest rates and a sharp rise in equity index volatility, this position has moved drastically against Berkshire. As of December 31st, 2008, Berkshire estimated that the equity index puts were now worth a gfair valueh of $10.0 billion and hence it had incurred a paper loss of $5.1 billion on the options. Although in his annual letter to shareholders Mr. Buffett is quite sanguine about the magnitude of these losses and their eventual outcome, I can assure the reader that my former equity derivative trading colleagues on Wall Street are notably less relaxed about Berkshire's equity index put positions.
First of all, Berkshire's estimate of fair value for the options assumes long-term interest rates and dividend yields of 4.0% and an implied equity market volatility of 22%. Based on my trading experience and using current market data for these pricing inputs, I estimate a fair value closer to $14 billion for the options as of year-end and a number approaching $16 billion as of the lows in the equity markets on Friday. Though Mr. Buffett argues at length as to the shortcomings of the Black-Scholes pricing model in his annual letter, I can assure the reader that former Wall Street colleagues are using pricing assumptions much closer to mine than to Mr. Buffett's.
Second of all, because Mr. Buffett is known to extract some of the best contractual terms when it comes to trading derivatives with Wall Street (so-called "most favored client" status), Berkshire was able to enter into these transactions without having to post any collateral at the outset nor in the future (see page 19 of the Berkshire Annual Letter).
Thus, since the value of the short puts has increased threefold and Wall Street has no recourse to Berkshire for collateral to cover its liability, Wall Street has suddenly become saddled with roughly $15 billion of Berkshire exposure, which is rather significant as Berkshire has only $30 billion in public debt outstanding. As a result, credit risk managers have been forcing equity derivative traders to buy CDS to protect against this exposure. This drive to reduce counterparty credit risk to Berkshire has been the principal culprit in the sharp rise in Berkshire credit spreads. The fact that Berkshire does not have listed equity options on its stock may also be adding to the CDS hedging pressure, as Wall Street cannot buy put options on Berkshire directly.
While this claim may seem outrageous, when one examines the relationship between Berkshire CDS spreads and my estimate of the fair value of its short index put portfolio, one can see that the two move nearly in lock-step with each other with a daily correlation of 0.96.
Finally, it has even been rumored that Mr. Buffett used a particularly toxic form of equity index derivative known as a "worse-of-option". In this case, one bets on the performance of the worst performing index among a basket of indices. Such an option can be worth significantly more than an option struck on the performance of the overall basket itself. So, let us assume for the moment that Mr. Buffett is correct and the US equity market regains its current 56% loss by the time the Berkshire options expire between 2019-2028, yet somehow Japan or European does not.
Berkshire could then, in theory, still end up owing money to Wall Street on the part of the $37.1 billion, which was linked to these "worse-of-options".
Not to pick on Japan, but 19 years later the Nikkei 225 Average is still trading at less than 20% of its all-time high set in December 1989 and is off over another 50% from the time of the Berkshire put option sales. And not to be overly depressing on the US front, one must all also bear in mind that the S&P 500 Index took 25 years to recover its 1929 highs.
So, Mr. Kneale, there is no mystery behind Berkshire's bloated credit spreads, which come as a result of Mr. Buffett's massive sale of equity index puts, the market's ensuing drop and Wall Street agreeing to waive its ability to demand collateral from Berkshire. The good news is that if the equity markets begin to recover, then the price of the Berkshire equity index puts will plummet and equity derivative dealers will shed their Berkshire CDS holdings, thereby driving down Berkshire credit spreads. However, the bad news is that if the equity markets continue to deteriorate, then Berkshire credit spreads may wider even further, as Wall Street will be forced to continue to reduce its Berkshire credit exposure related to equity derivatives.
So, bonne chance to Mr. Buffett and his short equity index put option positions, but I am afraid that Wall Street equity derivative traders and the CDS market will continue to fret over their Berkshire exposure for a considerable time to come.
