Berkshire Hathaway's Derivative Play

In its recent first quarter statement, Berkshire Hathaway (BRK.A) released that it has bought derivatives on various stock indexes that were set to expire between 2019 and 2028. The indexes of interest for Berkshire include the FTSE, Euro Stoxx 50, Nikkei, and S&P 500. The derivative plays included multi-billion-dollar positions that involved selling puts on the indexes. The report has Berkshire with $4.5 billion in premiums and $4.6 billion in liabilities at the end of 2007.

Apparently, Berkshire is not done and is continuing to increase its position, where premiums increased by $383 million after selling additional puts. This increases its derivative liabilities to $6.2 billion. In Q1 the positions went against Berkshire, causing it to record a loss of $1.2 billion. Given the long expiration dates, the losses appear to be mainly mark-to-market accounting losses, and not positions that have been closed. Each of the indexes that puts have been written against has been down for the year.

Of interests is that since $4.5 billion was generated in premiums in 2007, the notational value of the assets (indexes) themselves could be estimated to be in the range of $70-$100 billion. While Berkshire's insurance business has surely used derivatives to hedge risk, this direct speculative move into derivatives is both surprising and understandable..

On the one hand, Buffett has repeatedly talked about derivatives being "financial weapons of mass destruction," and something that has contributed to the current problems we are experiencing in the markets. Granted, there is a big difference between writing naked puts and writing a CDO-squared, where counterparty risk is not only huge, but often unknown. Nonetheless, it is interesting.

On the other hand, Berkshire's large insurance businesses have been providing a large float for Buffett to redeploy. The writing of naked puts will now provide extra income that can be put to work, albeit at a different level and degree of risk. Furthermore, the move signals that Buffett may feel that the market correction is over, and that the indexes are going up. If you believe this, as Buffett apparently does, then selling puts would seem more logical, and would also give you the cash you need to begin buying relatively cheap assets that you expect will be moving up from recent lows. Buffett has said as much, stating recently that he believes the worst of the credit crisis is over for Wall Street and the markets, even though individuals will still feel pressure. With the recent moves, Buffett is certainly putting his money where is mouth is, but is taking on more risk.

Finally, in addition to market direction bias, this move may also be giving us clues about the Berkshire insurance business, and the level of float that Berkshire needs and expects to receive in the future. Time will only tell how all this plays out for Berkshire and its shareholders.

Disclosure: Long BRK.B

Comments

[locke]

He mentioned this in his 2007 letter to shareholders. He said there is no counter-party risk because he sold them, he didn't buy them. I'm not sure selling puts is properly referred to as "buying" derivatives.

[teriyaki]

I believe the notional value of the derivative contracts is shown on page 7 of the 10-Q.

[LtShinySides]

No offense, but if you're going to write an article about derivatives, you should at least get your terminology straight. First of all, it's "notional" value, not "notational."... That word reeks of academia. Also, I'm not sure what you mean by "writing" a CDO-squared. Investment banks "underwrite" CDO-squared's, but in those cases, there is negligible, if any, counterparty risk to the underwriter. What I believe you were referring to is buying or selling protection on CDO-squared's using CDS. Counterparty risk does come into play then.

As for the merit of the argument or statement, whichever it may be, I'm not totally convinced that this move is purely speculative on Buffett's part as that would be totally out of character to use these derivatives for that purpose. It does seem like he's in effect doubling up risk on the surface, but it all depends on what he uses the premia for. Maybe he's looking to venture hard into the utilities business.

[David Enke]

LtShinySides, no offense taken. You are correct, on each account - the notional terminology is a slip - and one I must admit I have made before. I do hear other academics use it, mainly my math/engineering colleagues, so you may be right. Hard habit to break from my math/EE days. Nonetheless, it should be corrected. Your point is also taken regarding the CDOs. Here I was really just trying to make a bigger point about the types of derivatives Buffett was probably referring to when he made his "mass destruction" comment, compare to the position and exposure he is apparently now taking.

As for speculation, I really could not find anything that would describe it otherwise, but do agree with you that it appears out of character, especially with his recent comments on the matter. Not exactly sure where he is deploying the money, or if he is offsetting the risk in any specific way. I am kind of surprised more people are not inquiring about it. I did not make it to the shareholder meeting, so I am not sure how much he was pressed on the issue. I too would be interested to know the entire story regarding the position, if there is indeed anything else to it.

Thanks for having a look, and your comments.

[Nate C]

Buffett is hardly speculating on these derivative contracts. He only has to pay up if the indexes are lower than they currently are between 2019-2028 which is highly improbable considering the inflation factor. Unless you believe in financial Armageddon, Buffett will make a lot of money off these contracts. Unlike other counter parties Buffett does not have to put any of the premium money into an escrow account, but instead gets to invest the money freely for 11-17 years. No other institution could get this kind of sweetheart deal. I guess the counterparty feels that Berkshire's AAA rating is good enough.

On another topic, who would enter into such a puerile contract with Berkshire that the major stock indexes will be lower than they currently are 11 years from now? I have heard it was a few insurance companies who were hedging.

[LtShinySides]

Nate C,
Did he sell at-the-money or out-the-money puts? I'm not sure, and I can't find it. If he sold either of those types of puts, then I agree that more than likely, he's got a good thing going, especially while being able to invest the premia freely. Still, it's speculative by definition as you have tail-risk. Not that I believe "financial Armageddon" is occurring soon, but it has happened in the past that the indices decrease in 10-20 years. It's possible insurance companies would need to hedge at levels below the current market levels because of the inherent tail-risk of their business, but Berkshire's main business is also insurance, so who knows? Buffett no doubt has something up his sleeve that will make him and a lot of other people richer.

[sivere]

He could be in trouble, mainly because of great uncertainty, if we do what is currently required, namely,

TakeBackTheFed.com

[apawling]

Great write up- Its nice to see something on Buffett's activity in options, as he usually pooh-poohs them in his public statements. Although to interpret his activivty as speculation seems so out of character as to be unlikely.

Dave, have you seen any details on what the strike prices/indexes are for these puts? I would guess this is either a risk management move, generating cash for a big purchase, or a sign Buffett is changing tactics because he can't find anything compelling big enough to buy -something he complains about often.

[David Enke]

apawling, I have not seen anything specifically about whether they are in-, at-, or out-of-the-money options. The declared loss would imply they are most likely at-, given how one statement said they would not lose unless they fell below the value written at. Could be out- to some degree given the moves in some of the indexes, but the current losses imply at-, or just out-. In-the-money options would have also incurred a loss as well, and would give him more premium (float) to spend, but it would be out of character.

I also suspect Nate C is correct that since they are long expiration options, Buffett probably felt the risk was worth it. In fact, he is probably treating it like an insurance contract. There is always risk, but if you price it right, and properly spread the risk, you should be fine - which may explain the spread in option expiration dates. Nonetheless, if he is writing puts, then he is speculating in my opinion, but again, the risk is probably being managed more like an insurance contract. Of course, I am just speculating myself. Hope to find out more, but as you said, Buffett usually only releases what he needs to, and likes to temper expectations.