Berkshire's Huge Exposure? Nonsense

Here is the explanation of the much talked about equity options from the recent Berkshire Hathaway (BRK.A) Annual Letter:

Our contracts fall into four major categories. With apologies to those who are not fascinated by financial instruments, I will explain them in excruciating detail.

• We have added modestly to the “equity put” portfolio I described in last year’s report. Some of our contracts come due in 15 years, others in 20. We must make a payment to our counterparty at maturity if the reference index to which the put is tied is then below what it was at the inception of the contract. Neither party can elect to settle early; it’s only the price on the final day that counts.

To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 – down 10% – on the day of maturity, we would pay $100 million. If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In the meantime, the sale of the put would have delivered us a premium – perhaps $100 million to $150 million – that we would be free to invest as we wish.

Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24, 2028. We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future. Nonetheless, we have used Black- Scholes valuation methods to record a yearend liability of $10 billion, an amount that will change on every reporting date. The two financial items – this estimated loss of $10 billion minus the $4.9 billion in premiums we have received – means that we have so far reported a mark-to-market loss of $5.1 billion from these contracts.

We endorse mark-to-market accounting. I will explain later, however, why I believe the Black-Scholes formula, even though it is the standard for establishing the dollar liability for options, produces strange results when the long-term variety are being valued.

One point about our contracts that is sometimes not understood: For us to lose the full $37.1 billion we have at risk, all stocks in all four indices would have to go to zero on their various termination dates. If, however – as an example – all indices fell 25% from their value at the inception of each contract, and foreign-exchange rates remained as they are today, we would owe about $9 billion, payable between 2019 and 2028. Between the inception of the contract and those dates, we would have held the $4.9 billion premium and earned investment income on it.

Okay... So the $37.1 billion number we hear about as Berkshire's "exposure" is bunk. Berkshire is exposed to that number IF the value of both European, U.S. and Japanese stock markets goes to zero. A true Doomsday scenario that, should it happen, essentially means the end of all economic activity as we know it.

So, someplace between "end of the world" and "normal economic activity" is where we end up.

Let's look closer. The question is, "how much does Berkshire have to annually compound the premium received to pay off the contracts if need be? In order to do this some assumptions are necessary.

• I will use 17.5 years as the expiration as it is the middle ground on the contract expiration and no further details are available.
• I have to assume equal index losses should they occur at the end of the 17.5 years as there are no details available as to the weighting of contracts in what years.
• I will also use the S&P solely as the index the puts are written in as it is the largest market by far and most likely contains the largest exposure.

Here are the necessary compounded annual rates of return necessary on the $4.9 billion in premiums received in order to pay off the bet should the indicies fall by "x" percent.

BUT, you say, what about the other question? What level were the indexes at when the options were sold? We know the majority of them were entered into during 2007 (some in 2006 and 2008 with Index levels lower than 2007). But, for the example I will say the S&P was at 1500, about the high of the year.

Then how much must the S&P grow between now and 16.5 years (I use 16.5 since one year of the contract has elapsed) in order for Warren to avoid paying off at all. Now, it should be noted that in 2008 at lower levels Warren added to the contracts which in reality would lower the necessary index returns but let's just use the most extreme example to illustrate, all contracts written at market highs.

The S&P must grow 4.5% annually for 16.5 years from today's 727 to eclipse 1500 and allow Warren to avoid paying off. Remember, this is "worst case" index contract inception number, the actual amount is lower.

What are the odds? Well, since Berkshire officially in 1965 became Warren's he has grown value by 20% annually and the S&P has grown 8.9% annually.

Using those numbers, the S&P in 16.5 years sits at 2968 and Warren's $4.9 billion premium has been grown to $119 billion free and clear for Berkshire shareholders. If we assume sub-performance for both of 50% less than the historical averages, the S&P sits at 1491, Warren pays off a pittance (maybe a couple million) andhas grown the $4.9 billion to $25.9 billion for Berkshire.

The reality is this is just another insurance policy for Berkshire. In the event of a dramatic event they pay off big, anything less, they collect premiums.

The next time someone tells you about "Berkshire's huge derivative exposure", please send them here...

Disclosure: None

Comments

[gjvoor1:]

I have been wanting to look at this deal, but never took the time. Thanks for the good analysis. I wonder who is on the other side of this bet.

Mar 12 09:12 AM

[nap1:]

Your article explains this very well. But I am still wondering why the other side is willing to shell out this premium for something that has a very remote possibility of happening, and if it happened, wouldn't cost them much just like it may not cost Berkshire much.

Mar 12 10:16 AM

[PenName Dave:]

Excellent chart there... sums it up perfectly. Thank you for doing the calculations on premium annual return needed. Thats exactly the thinking Mr. Buffet used in making those decisions.

It amazing how quick people are to tear down and disregard people who have such a strong track record.

I recall a story about Bill Walsh, the former 49ers coach who drafted and traded for Joe Montana and Steve Young. After he retired from the NFL and was still living in the bay area he had an opportunity to get to know Jeff Garcia and see him play at San Jose state. Walsh called several teams on behalf of Jeff Garcia as the draft was approaching and told them that he though Garcia would make a good NFL quarterback and was certainly worth a draft choice.

No team drafted him.... or invited him to their camp. Jeff Garcia played several years in the CFL before he got a shot in the NFL.

No one could have done more to establish credibility in the area of NFL quarterbacking than Bill Walsh... and still no one listened.

No one could have done more to establish credibility in the area of investing than Buffet... and I see commentary about him like he's been discredited and shamed.

No one is right all the time, but some people do better than others :D

Mar 12 02:02 PM

[Owen:]

For those wondering about the counterparty to those index put contracts, one possibility is Index-Linked Notes.

Many financial institutions are now selling investment instruments that offer the market return if the index goes up, but guarantee your principal in case it goes down. They make their profit by collecting the dividends on the portfolio (or the interest, if they use futures contracts), and by capping the return if the market goes up beyond a certain level (which allows them to write covered calls on the portfolio).

However, to retain their credit rating, they must fully hedge their exposure in case the market goes down. They do so by buying long term put contracts on the index. If priced correctly, they can ensure a fixed, predictable profit for themselves, without exposing themselves or their customers to any risk--beyond the counterparty risk on the puts. That's why they'd choose Berkshire, the most trusted insurer around.

Mar 13 07:04 PM

[Tom Jacobs:]

Recognize the similarities between what Berkshire has done here and what AIG did selling protection on AAA rated CDO tranches. Sell large amounts of "insurance" via derivatives and rely on not having to post collateral to argue the unlikely situation that any payoff will occur or call into question mark to market accounting. Argue it is free money as the author here is doing by showing how unlikely a loss is or how little it costs over time. It is unclear if Berkshire has "paid out nothing" because they are AAA or because their contracts are free of collateral requirements. Fitch downgraded it to AA+ on March 12 so we will soon see.

I still cannot get over the hypocrisy in all of Buffet's "derivatives are weapons of mass destruction" hysteria. He can't have it both ways. If anyone can justify selling these large option positions from a speculative position (there is no hedge here) then how are derivatives such evil contracts?

Mar 21 12:06 AM