Berkshire Hathaway Faces Higher Funding Costs Now

Berkshire Hathaway (BRK.A) sold $750 million of three year 4 percent notes yesterday priced to yield 282 basis points more than Treasuries of similar maturities based on several news stories published yesterday. Berkshire Hathaway Finance Corporation has issued the debt to provide funds for the Clayton Homes subsidiary for purposes of mortgage origination. I wrote about Clayton homes earlier this month and noted the company’s admirable track record related to its lending practices and the low default and foreclosure rate of its loans.

Earlier this month, Fitch Ratings downgraded Berkshire Hathaway’s credit rating on unsecured debt from AAA to AA+. Earlier this week, Standard and Poor’s lowered its outlook on Berkshire Hathaway from stable to negative. The result appears to be at least partially responsible for a slight increase in Berkshire’s funding costs. While yesterday’s notes were priced to yield 282 basis points over Treasuries, the yield spread was only 220 points in January when Berkshire sold $250 million of 5.4 percent notes due in 2018.

Rock of Gibraltar vs. Financial Cripples

In Warren Buffett’s annual letter to shareholders, he made reference to Berkshire’s higher than normal funding costs compared to competitors receiving government aid. Note that Buffett wrote this letter prior to the actions by Fitch and Standard & Poor’s in March:

Clayton’s lending operation, though not damaged by the performance of its borrowers, is nevertheless threatened by an element of the credit crisis. Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.

Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

When Berkshire issued the longer term notes in January, these conditions were surely on Buffett’s mind and it appears that the spreads are even higher now that Fitch and Standard & Poor’s have lowered their outlook on the company.

The Power of the Ratings Agencies

As I wrote in my prior posts on the Fitch downgrade and the Standard & Poor’s negative outlook, I consider the actions to be almost entirely without merit. In particular, Fitch used highly dubious logic and partially based their downgrade on Berkshire’s derivatives exposure which continues to be widely misunderstood despite Buffett’s crystal clear explanation of the true nature of the contracts. However, regardless of whether these actions had merit, they have at least slightly raised Berkshire’s borrowing costs. This is in addition to the impact of the already wider spreads compared to competitors with access to government guarantees. The combination of these factors will obviously reduce overall profitability and will probably also raise borrowing costs for Clayton customers financing their purchase with funds from these borrowings.

It is ironic that the ratings agencies continue to exert this kind of influence in the markets. It seems like there is a major effort underway to make amends for the fact that the agencies missed major blowups over the past year and kept AAA ratings on senior tranches of mortgage backed securities as well as AIG debt until it was painfully obvious to everyone that downgrades were warranted. With Berkshire, it appears that the pendulum has swung the other way in a rather extreme manner. There are many proposals circulating regarding a reform of the ratings system. It seems like such proposals should be carefully studied since the current system appears to be broken.

Disclosure: Long Berkshire.

Comments

[David Clayton]

@Ravi Nagarajan: You wrote: "While yesterday’s notes were priced to yield 282 basis points over Treasuries, the yield spread was only 220 points in January when Berkshire sold $250 million of 5.4 percent notes due in 2018."

Please consider these other data points that help to explain differences in the Treasury-corporate yield spread:

1. It appears that as maturities increase, spreads tend to narrow. The spread on 10-year notes is running about 297 bp right now, while on 5-year notes it's about 339. Berkshire's bonds this week mature in 3 years, and I think should be expected to have a wider spread than its January bonds, which mature in 9-years.

2. Spreads are different now than in January. They've mostly narrowed. Yields on 5-year notes are 13-14 bp lower, while on 10-years it's 5 bp.

I guess the differences in the lending market and the maturity lengths explains something more than half of the increased spread.

2009 Mar 27 10:01 AM

[Ravi Nagarajan]

Thanks for the comments. I will examine those additional data points. It may be difficult to isolate the impact of the ratings downgrade from broader shifts in spreads to determine how much more BRK is paying now than they would be in the absence of the downgrade/negative outlook. There certainly seems to be some impact but perhaps you are correct that some of the difference is related to other factors.

2009 Mar 27 10:17 AM

[mkreisel]

One thing is certain though: the CDS price on BRKA is utter crap.

2009 Mar 29 01:39 AM