Fran the man

Buffett Serving Free Lunch?

Fair point, provided BRK accesses public markets for debt and such debt is priced with reference to the BRK's CDS spread. However, BRK uses very modest levels of conventional gearing and, in its main business of insurance, credit ratings from the ratings agencies remain all important.





On Nov 25 11:50 AM raytayzmd wrote:

> This guy better explains what I'm getting at:
>
> "He (Buffett) has the cash, he doesn't have to post collateral (we
> hope), he's comfortable that in 18 years the market will be 65% higher,
> and he claims he doesn't care about the mark to market risk. I'm
> not sure he thought it through completely though: even if he has
> no collateral issues, the action of the person covering themselves
> against his risk certainly does, and that person is screwing up Warren's
> ability to finance himself elsewhere."
>
> crookery.blogspot.com/...
>

Buffett Serving Free Lunch?

Yes, you are right, BRK will have to recognise the liability on their Balance Sheet and mark-to-market/model the “fair value” movements in these puts.

However, from a credit worthiness perspective, the approach the ratings agencies (who are the final authority when it comes to credit risk) will take would be to look at the terms and tenor of the obligation. BRK has written these at-the-money puts for a duration of 15 years (minimum) and does not have a present obligation to settle this “debt”. Remember there is a condition probability here a.) firstly the indices must close below the agreed value, and b.) should this occur BRK must pony up the cash to the extent the puts are in the money (for the counterparty). BRK can only ever default on this obligation (should it be in the money for the counterparty) in 2019 and longer dated debt carry a much lower weighting than shorter dated debt in assessing credit risk (to clobber this point to death: BRK cannot default on this obligation for 11 years still).

Secondly, and more importantly, what all this illustrates is the inherent limitations of accounting (don’t get me wrong accounting is imperative for the proper functioning of capital markets, but will never be an exact reflection of economic reality). This BRK put is a case in point: the question here is what is the economic reality for BRK? Let’s take the S&P500 put as an example, firstly obviously Mr Buffett is bullish about the prospects of the American economy (and probably an increase in inflation) with a resultant increase in the underlying nominal earnings of the S&P500. During 2004 (when these options would have been written) the S&P500 earned c. 63 per unit and S&P500 was trading at 1150 (the S&P500 on was trading at or slightly above its long run historical average in terms of. price earnings, price-to-book, price-to-sales etc.).

Should nominal GDP growth in the US average 5% p.a. (say 2.5% inflation, 2.5% real GDP growth) the S&P500 would earn 131 p.u. in 2019, at 1150 this would translate into a PE of 8.8. The S&P500 has traded at this multiple or lower only 35 quarters out of 288 (i.e. since 1936). Although possible it is not probable. Also bear in mind that the S&P500 is subject to survivorship bias i.e. if a company loses a big chunk of its value a new, higher valued, company will be included, introducing a upward bias to the S&P500 (and an additional benefit for BRK) vs. e.g. a single stock reference asset.

The above illustrates the practical reality, BRK’s thinking and the economics. With respects to the real cash flow argument there is truth to the argument that traders will be able to sell these puts at the prevailing market price to other traders. That is exactly it: other traders, the real patsies are the traders trading this thing because at some point, like all other market inefficiencies, it will correct and pity the poor sole stuck with it who bought it using historical volatility to value it instead of looking forward.



On Nov 24 11:21 AM raytayzmd wrote:

> ...however, that put sits on BRK's balance sheet its entire lifespan
> and has a negative effect since it has to be accounted for...presumably,
> that currently has a negative effect on the company's credit worthiness
> and increases costs associated therewith...a pertinent question is
> how much effect will that be?

Buffett Serving Free Lunch?

I refer you to an articles written by Mr Buffett (it was actually a speech he had made earlier in 1999 distilled into an article published by Fortune the same year).

homepage.mac.com/bobem...

My personal view is that this is the only article one ever needs to read to understand the fundamental drivers of any financial asset (and specifically stock valuations).

Any one who wants to understand his thinking in structuring the options (and I can promise you he did it without ever looking a Black Scholes valuation model) and the real economic implications for BRK.

Interesting fact about the article referred to above; it was written when the Dow Jones Industrial Average was at c. 9150. Last I checked it was at c. 8200. Remember this was in the heady days of the Internet Bubble when books entitled: Dow Jones 36 000 were in vogue and everyone had their 401k's in Pets.com.

He was right then and I'm willing to write you a binary option he'll be right again.