Buffett's Letter to Uncle Sam Disguises Real Reasons for Gratitude

Includes: BRK.A, BRK.B
by: Madhusudan Rao

It comes as no surprise to me that Warren Buffett sent a Thank You note on November 16th to Uncle Sam. Unfortunately, his “Thank You” note seems to indicate that Uncle Sam actually bailed out the American Economy and not Warren Buffett’s investments. Mr. Buffett suggests that a lack of intervention would have brought the whole US Economy to a standstill. Sure, a lot of companies would have suffered and many Americans would have lost jobs. But the Berkshire Hathaway (NYSE:BRK.A) shareholders would have lost a lot too. And Buffett, rightly so, has acted in the best interests of the shareholders in thanking Uncle Sam for this benevolence, although he has disguised the real reasons. It is not just Berkshire Hathaway as a holding company that would have suffered, It is also the derivative contracts that would have caused a lot of losses. And these losses wouldn’t have been just “marked to market”. They would have been real losses.

Here is a look at the potential losses based on Berkshire Hathaway’s annual reports. In 2006, Mr. Buffett indicated that he held 62 derivative contracts. In 2007, He stated that 54 contracts are related to bonds that are included in various high-yield indices. And these contracts expire between 2009 to 2013. In the worst case scenario, Mr. Buffett would have had to shell out $5.2 billion, and since he had collected $3.2 billion premiums, the net loss would have been close to $2 billion. And if the Fed had not bailed them out by inducing trillions of dollars of liquidity, there would have been a very high chance of default and it is safe to assume that the “worst case scenario” could have been the “most likely scenario”.

Again, in 2007, Mr. Buffett revealed in his annual shareholder letter that he had collected premiums worth $4.5 billion on various put options on four stock indices. “These puts had original terms of either 15 or 20 years and were struck at the market.”

The 2008 Annual Shareholder letter gives more details about the contracts. Even if we assume that most of the contracts were written with an average strike price of 1100 (for S&P 500), Mr. Buffett is likely to lose a lot of money if S&P 500 goes below 850. In his own words,

If, however – as an example – all indices fell 25% from their value at the inception of each contract, and foreign-exchange rates remained as they are today, we would owe about $9 billion, payable between 2019 and 2028. Between the inception of the contract and those dates, we would have held the $4.9 billion premium and earned investment income on it.

That is a loss of $4 billion on the contracts alone. If we assume that he invested the premiums back into the market and the market tanks, he can lose about 30% of his $5 billion premium. So the total losses would be approximately $5.5 billion. If we assume that the markets could have fallen 50%, the net losses could even be close to $13 billion on contracts and additional $3 billion losses (60% of premium collected) on investments of the premium which amounts to $16 billion. This amount is regardless of the other losses in his investment portfolio. On Credit default swaps too, with the credit risk of 42 corporations, there would have been a very high likelihood of losing another 50% of the contract value which amounts to $2 billion. All said and done, with Hang Seng rising, Nikkei and S&P 500 falling , there was and probably still is a strong chance of a $15 to $20 billion losses. Some credit contracts have of course run off though.

Fast Forward Feb 26, 2010, when 2009 annual letter to shareholders was released, Mr. Buffett clearly states that

We have since changed only a few of our positions. Some credit contracts have run off. The terms of about 10% of our equity put contracts have also changed: Maturities have been shortened and strike prices materially reduced. In these modifications, no money changed hands.

The Fed, by printing money, not only saved Berkshire Hathaway from the credit risks/default risks and high yield bond contracts, but also moved the broad indices north of 1200, thereby giving Berkshire Hathaway favourable conditions to renegotiate the derivative contracts.

Here is how the scenario is probably going to play out. The shareholders are going to receive the annual letter in February 2010 or February 2011 (I don’t know when) with the following statements:

1. While times are still good and improving, Charlie and I have decided to close all our equity derivative contracts as it is out of our “circle of competence.”

2. The contracts had not only created very high volatility in quarterly earnings, but also shareholder anxiety, which is not desirable.

3. After Moody’s downgraded our credit rating and the financial regulatory reforms required us to put a margin for the premiums we collected, Charlie and I felt that it was not the most profitable use of our funds to hold on to the derivative contracts.

What will also be implied is: We might plan on (or already have) insuring(ed) a few muni-bonds and collect(ed) premiums on them, because the Fed will definitely rescue us from those bonds as well. It is in the best interest of the country to keep the muni-bonds from default and it will serve a greater purpose for Americans. In the meantime, I would like to collect the premiums for my shareholders.

Well, Mr. Buffett, with the Fed on your side of the trade, you don’t have to be the Chief Risk Officer. And let the tax-payers bear the brunt of your experiments in derivatives.

Disclosure: No positions in BRK.A