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Why Berkshire's Cutting Back on Reinsurance

I believe that Buffet said this in one of his interviews that he will write less cat insurance in the near forseeable future to mute Berkshire's overall risk exposure. It's a good lever to be able to use -- less volume also likely means better pricing on the contracts that they actually end up writing.
Contary to writer's opinion, I'm not sure that Moody's AAA or CDS spreads have anything to with Berkshire's perceived counterparty risk. IMO, there aren't any better options, not even close.
Wall-strret types who consistently juiced their balance sheet 8-10x, live their lives obsessing with CDS spreads or AAA-rating, because it is a way to justify their leverage to regulators and risk managers. Not sure it's a valid measure for a non-levered company with a decent cash cushion and generating more cash every quarter. As long as you don't confuse cash flow with reported earnings.

Explaining the Berkshire Share Price

Felix - Your point is well taken. There are multiple ways to analyze an investment and a good investor should use multiple models to evaluate potential investments (to borrow a Munger favorite). Ultimately, the point of all investment is to buy something for less than it's worth using a range or probabilistic outcomes. (For that reason, I love the current share price)

Now, the CDS market could be on to something here. It could simply be a case of someone spreading the risk of BRK as a counterparty to others. I think the price (and underlying probability of default) could be useful if these levels persist or if the name of parties becomes known (or really their motivation).

I disagree with you that Berkshire is a much riskier investment that a few months ago. A number of risks have already materialzed and have impacted competitors much more leaving BRK in a position to cherry pick some amazing opportunities. I think this is rear view driving at its best.

paultaut - Can you substantiate your assertion that Buffet's index puts are a time bomb waiting to explode. He has covered this in pretty gory detail in the recent report and his logic made sense to me. Wondering if you could fill the rest of us in here on why you consider this dangerous.

Berkshire Hathaway: Failing Business Model Points to a 35% Decline

Rakesh,

A central tenet of Buffet's success is that he's figured out better than most which risks to take, which ones to avoid and more importantly adequate compensation for taking on those risks -- whether on the underwriting side or equity investing side. He's been prepared to walk away from business when premiums are inadequate. In my book, if current premiums understate risk, it'll be great thing for long term Berkshire shareholders (with oodles of short term volatility) as the competition will not be able to survive such an event.

Frankly, Berkshire's index puts have been discussed ad-nauseum on this web-site in various degrees of negativity -- accounting/non-cash losses, impact from increased volatility etc. I'm not sure what the brouhaha is. Non-cash charges don't mean anything in my book. The puts are not priced on the basis of volatility. Their maturities are staggered over a long period of time and they are written on different indexes. The stock market has bever seen such an extended period of underperformance. If the market does underperform over such a long period of time, Berkshire will generate lots of capital to invest at depressed/attractive levels.

I personally am not wired to be short things, but have no problems with people who can figure it out. In the short term, I don't see a lot of reasons to be long anything, however most money is made by investing during such times in durable franchises. As regards valuation -- equity prices are really driven by future cash flows. The fundametal mistake that people made recently is to assume that the long term future will very much resemble the recent past. Perhaps, people are repeating that same mistake in assuming that no one will ever make any money in business again.

I have read (and enjoyed) some of your other articles. It's rare on this stie to see good/forthright analysis. Thanks.

Aashish

Burlington Northern Santa Fe: What's Buffett's Strategy?

Good, insightful article.

Doug Kass's Killer Shorts - Barron's

I like Mr. Kass's shorts, at least he's original...
Quick note re: Fastenal. Shorting Fastenal is a tough way to make a living. I'd much rather short HD, LOW or even homebuilder stocks. If FAST has a bad day, HD and LOW will likely suffer in sympathy. But, wait, these stocks are probably shorted by everyone and their brother, so Mr. Kass is worried about losing money on a short covering rally.

One correction that I'd like to suggest...Berkshire did not lose 1.6 bilion on derivatives contracts. It sold equity puts on major US indices for 20 year periods and got premiums upfront. These contracts are essentially like selling an insurance policy to someone. Buffet gets to invest the float for 20 years and may not even have to pay anything (and will likely make 3x-4x by investing the float). The The 1.6 billion "loss" is just the fair value accounting at work and will likely fluctuate up and down every now and then. Outside of the up-front premium, no money changes
hands till contracts are settled.


Pasting from Berkshire's 10-Q:
"The estimated fair value of the equity index put option contracts at March 31, 2008 was approximately $6.2 billion, an increase of $1.6 billion since December 31, 2007. The increase was primarily due to fair value losses of $1.2 billion as well as $383 million in premiums from new contracts entered into in 2008. There were no cash payments made under the equity index put option contracts.
The aforementioned contracts are not traded on an exchange. The contracts were entered into with the expectation that amounts ultimately paid to counterparties for actual credit defaults or declines in equity index values (measured at the expiration date of the contract) will be less than the premiums received. The contracts generally may not be terminated or fully settled before the expiration dates (up to 20 years in the future with respect to equity index put option contracts) and therefore the ultimate amount of cash basis gains or losses will not be known for years.
Berkshire does not actively trade or exchange these contracts, but rather intends to hold such contracts until expiration. Nevertheless, current accounting standards require derivative contracts to be carried at estimated fair value with the periodic changes in estimated fair value included in earnings. Fair value is estimated based on models that incorporate changes in applicable underlying credit standings, equity index values, interest rates, foreign currency exchange rates, risk and other factors. The fair values on any given reporting date and the resulting gains and losses reflected in earnings will likely be volatile, reflecting the volatility of equity and credit markets. Management does not view the periodic gains or losses from the changes in fair value as meaningful given the long term nature of the contracts and the volatile nature of equity and credit markets over short periods of time."

Is Berkshire Hathaway Now a Bargain?

There are two distinct pieces to any Berskshire related discussion .
Let's talk about intrinsic value first. Despite its present size, berkshire's oerating businesses should grow earnings at a 10+% clip over a full business cycle. Performance will be lumpy (insurance pricing, super cat performance, housing and economy), but for someone with a long term view, these businesses will grow earnings. This portion of berkshire does not have a huge dependence of Buffet as performance is driven by talented and motivated managers. Moving to investments, it's investment portfolio is positioned superbly. If I'm doing my math right, Buffet deployed 20 billion in bonds recently and still has a war chest of 20+ billion remaining (growing by 8+ billion every year). Most of the existing 70+ billion equity portfolio is invested in 15+% ROE opportunities. It's safe to say that intrinsic value over longer periods of time will grow at 15% but growth will be lumpy.
The stock price will be affected by two factos: lumpy growth and how markets value liquidity. Lumpy growth has been a way of life at berkshire and is one of things I like about berkshire. When liquidity is freely available and the rest of world is levering (tons of stupid money chasing all kinds of model driven gains), berkshire's stock price will languish. When the opposite happens and the leverage is unwound, people will disregard buffet's age and embrace the war chest and AAA rating.
If your edge is patience and a longer time horizon, a long position in berkshire at today's prices can double your money in the next 5-6 years. Beyond that, there are any number of ways to make something simple more complicated.