dlaw

Buffett Closes Derivatives Contracts, Goes Back to Writing Insurance

Yeah, people know how options work, particularly people who buy and sell stocks. They also know how float works. That's why Berkshire is down today.

The problem is that Buffett isn't making money from the float. He's investing in the wrong things. He hasn't lent money. He has bought equity in companies, making himself a junior creditor at companies, some of which are in danger of going out of business altogether.

On top of that, rather than placing a bet the market isn't aware of and can't bet against - like a *real* insurance policy - he has placed a huge, very public bet. This means that options players - particularly those who took the other side - will skew the public markets against him.

Let's look at the other side of the trade: those players paied $4.9 billion and now, unlike Buffett, have a huge assett on their balance sheet. Since they are probably leveraged institutions, that asset is saving them from having to borrow money. Relieving the burden of debt is the surest and most-profitable use of money there is.

Buffett figured that the knock-down to his balance sheet would cost him nothing, therefore they were mispricing the benefit relative to him. He wouldn't need to borrow under any circumstances. And yet there he is, whining in his letter about how it's so expensive for him to borrow money.

And, Buffett completely blew the volatility calculation.

So my question would be: which calculation did he even get right on that trade?

Buffett Serving Free Lunch? (Part II)

Edifish,

Thank you for your interest.

I think you'll find it's not a case of conspiracy theory or anything else.

Some people bought some things (the puts) that have appreciated enormously in value. If these people are risk averse, as you suggest, then it's even more likely they will act to put the money in their pockets and invest it in safe instruments.

These are private transactions, so there is no direct evidence, but somebody has been buying a lot of Berkshire CDS. If Berkshire isn't going broke (and it isn't) why would someone do that? The most likely answer is what Mr. Clavell suggested - a hedge.

Buffett Serving Free Lunch? (Part II)

TomR - I'll leave it to experts to fill in the amounts, but I would say:

Sell puts very similar to the ones Berkshire sold but at the much-higher-price they would command in the market today, thus netting out the position. Their cash profit would be what they take in versus what they paid Berkshire.

They could use some of the money to buy calls or go long futures as well, thus profiting from the upside as well as the downside.

And they could buy CDS to hedge the risk that Berkshire won't be able to make good on the promised payment.

Buffett Serving Free Lunch? (Part II)

Just to try one more time, the Berkshire options are not (so far as I know) exchange traded. But the people hedging those options will do so on exchanges. Because Buffett so badly mispriced so very many options, the options market itself - for those strikes - has been mispriced.

It's an indirect, probability-based effect, but it is a real effect.

These markets are all connected. Again, a one trade in the market affects ALL other trades. That's just the physics of it.

Buffett Serving Free Lunch? (Part II)

Thank you all for the comments.

All of the comments basically hit the same topic and I should have mentioned it in the piece.

First, those who say that Buffett can hedge haven't thought it through and don't know Buffett. The cost of hedging will be astronomical and easily wipe out any profits he might realize by holding to expiration and Warren Buffett is not really a guy who hedges (although his increase in CDS bets smack of a "double down"). His only saving grace in this thing is that he does buy and hold.

So Buffett really has to hold the options and suffer the consequences of failing to price liquidity risk. Remember how far away from the market these options will be. That's a huge inventory overhang in the out-of-the-money strikes. It will skew the options market for many years to come.

Berkshire Bond Yields vs. CDS Rates

"Real, economical, pure free money." - incredible. Something about Warren Buffett causes people to live in a complete fantasy world.

But the author does show exactly why the CDS are so expensive: CDS are not only a default aritrage, they are also a spread arbitrage. While there are credit spread swaps (which would be the more-precise way to play a spread arbitrage) apparently CDS are the larger market.

If BRK bonds are trading at a premium to the AAA market, then CDS are a perfect way to play the arbitrage between BRK bonds and the AAA market. Since the derivatives losses seem a no-brainer to at least move BRK bonds down 133 bp - as the author notes - there is a nice, built-in cushion to the downgrade/default play.

So thanks to the author. Sometimes you can learn what's right by reading what's wrong.

Buffett Serving Free Lunch?

I'm sorry, but I must respond to the last comment.

***I*** don't know anything? I?

First, this is a question. Money has been made. A premium, therefore, must be delivered to the market. I ask where the readers think this premium comes from and how it affects BRK. Is the loss probabilistic? Yes. Does that mean it's unreal? No. Clearly it is real. The idea that "in the long run it always goes up" is exactly the kind of unrigorous thinking that got America in this mess. Remember when real estate "always" went up?

Forget the Brooklyn Bridge - I've got a development in the Imperial Valley I'd love to sell to anyone who still thinks that way.

I regularly read the most ridiculous things about Buffett which add up to the same, spurious conclusion: "Buffett can't be wrong, because he's Buffett." I read recently how it's okay that the options have gone tragically from at-the-market to out-of-the-money because there is less vega loss as options go out of the money. By this "reasoning" if the indices lose another 40% Berkshire has scored some vega coup.

If a batter gets down 2-0, that batter is not out, but he has lost an immense amount of the probability of success. As such he "loses" much of the plate. It weakens his position as this derivatives disaster has weakened Berkshire's position.

The people who took the other sides of these trades were not children. They were not idiots. They knew they were betting against one of the best investors in history and they - not he - won. How do I know?

They have money in their pockets and Berkshire has losses on its balance sheet and that is the final arbiter of who wins and loses in the game Buffett plays.

There is no free lunch.

Berkshire Hathaway Credit Risk, Index Puts Are Overblown Worries

I'll bet Goldman Sachs sold him the derivatives.

Then they sold him the company.

Nice trade.

Buffett's Gamble: $40 Billion Bet on Volatility

Muzie,

The kid is saying that Buffett is profiting from the bull market in volatility.

In fact, Buffett is GETTING KILLED by the bull market in volatility on an enormous portion of these puts.

Repeat: Buffett was on the WRONG side of the volatility trade in 2007.

Do you not get that???


On Nov 21 05:34 PM Muzie wrote:

> dlaw: They expire TWENTY FREAKIN' YEARS FROM NOW.
>
> There's no "bath" taken because he's not going to trade in or out
> of them. Your "bath" is simply he could have written off those same
> puts for more money now then before. That's like saying he's taking
> a "bath" because he could have bought a rising stock for the lowest
> possible price but instead bought it 10$ more while turning down
> a profit.
>
> You wake up!

Buffett's Gamble: $40 Billion Bet on Volatility

Author, read the Berkshire letter again.

Buffett sold many of these puts when volatilities were much, much lower, therefore he was on the wrong side of the volatility trade. You want to be a buyer of long-dated options as the VIX goes up.

Buffett has taken a bath on these options.

Wake up.

Will Berkshire Lose Its Triple-A?

More denial in the comment field.

So far, the CDS market has been prescient about imminent collapses.

From Berkshire, we will, of course, hear nothing but lies as we head nothing but lies from every single doomed financial firm. And of course everyone on Wall Street will believe the lies.

What choice do they have? Blame themselves?

And of course Warren Buffett cannot be wrong. It's not physically possible in the minds of most in the investing world.

I don't know what the truth is but before people start blaming the ratings agencies for committing "financial terrorism", I would remind people of this: Berkshire OWNS an interest in a rating agency.

So wouldn't it be just as logical that the ratings agencies had covered up for him?