On Buffett's Big Blunder

Warren Buffett is getting a lot of criticism for a big blunder. He sold put options on four stock indexes – including the S&P 500.


Buffett described these derivatives in his 2007 letter to shareholders:

“Last year I told you that Berkshire had 62 derivative contracts that I manage (We also have a few left in the General Re runoff book). Today, we have 94 of these...”

Financial Weapons of Mass Destruction


Before criticizing Buffett, we need to take a moment to praise him. After all, the guy had the foresight to clean out the General Re derivatives before the credit crisis hit.


Yes, Berkshire Hathaway (BRK-A) (BRK-B) took a loss. And, yes, Buffett clearly overestimated both the rationality and morality of the human capital over at General Re – much as he had at Salomon.


Buffett was never well-liked at Salomon. And I’m sure there are some folks (or ex-folks) at General Re who don’t find him quite as avuncular as he is reputed to be.


I would say they simply don’t understand each other, if I didn’t think the truth was exactly the opposite. Buffett got to know Salomon and General Re better with time – and the better he knew them, the less he liked them.


The General Re derivatives were a disaster averted. Had Berkshire kept the book intact or never acquired General Re, we’d be hearing a lot more about what was in that book.


Is it a mere coincidence that Buffett, the CEO who made the decision to unwind the General Re book, called derivatives “financial weapons of mass destruction”?


No. Buffet saw something in that book. And he did something about it. Most CEOs did not.



Style Drift


Enough praise. Back to the blunder:

“Over the past five years, Buffett frequently called derivatives ‘financial weapons of mass destruction’, comparing derivates to ‘hell...easy to enter and almost impossible to exit.’ Yet, he has, very much out of character, immersed himself in a large and, thus far, unprofitable derivative transaction. His investment successes have not been in speculating in the market (something he has been critical of) but rather by purchasing easily understandable companies with dependable cash flows…”

That’s Doug Kass writing lasting year about Buffett’s style drift. He goes on to write:

“It immediately occurred to me after gazing at Buffett's style drift (manifested in Berkshire Hathaway's large first quarter derivate losses) that he might be increasingly viewed as the New Millennium's Ben Franklin, a man who wrote ‘early to bed and early to rise’ but spent many of his evenings in France, whoring all night…”

Not surprisingly, Kass is negative on Berkshire stock. I won’t argue that point. Berkshire has fallen. And short sellers have made money.


Kass presents Buffett’s derivative transaction as “speculating in the market”.


Insurance


Let me offer an alternate explanation.


Berkshire Hathaway has substantial insurance operations. It is, in fact, a huge insurer of large, often unusual risks. In some cases, Berkshire prefers to keeps such risks to itself instead of sharing them with other insurers.


Buffett does not believe in the Noah’s Ark school of investing and Berkshire does not practice the Noah’s Ark method of insuring. The company bets big in stocks and takes big risks in insurance provided the odds look good and the cost of a losing bet would not imperil the holding company’s health.


That’s the business model. And I love it. If you don’t love it, don’t buy Berkshire. Buffett has been explicit about both parts of the process – the generation of float and the allocation of capital – and he has been explicit about the fact that Berkshire is not a conventional insurance company.


This brings me to a critical point. I disagree with Kass. The put options Berkshire sold aren’t an instance of style drift, because they aren’t investments – they are insurance.


Here’s how Buffett described them:

“These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at the expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make payment only if the index in question is quoted at a level below that existing on the day the put was written…I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15-or-20 year period…in all cases we hold the money, which means we have no counterparty risk.”

As Whitney Tilson noted, it appears Berkshire is not required to post (much) collateral:

“Under certain circumstances, including a downgrade of its credit rating below specified levels, Berkshire may be required to post collateral against derivative contract liabilities. However, Berkshire is not required to post collateral with respect to most of its credit default and equity index put option contracts and at September 30, 2008 and December 31, 2007, Berkshire had posted no collateral with counterparties as security on these contracts.”

Trust


Considering these facts, two possibilities exist:


a) Buffett is lying or otherwise intentionally and materially misrepresenting Berkshire’s derivatives situation.

b) These derivatives pose little to no risk to Berkshire’s solvency or long-term financial health


If Buffett is lying, Berkshire’s shareholders are screwed. But that’s not news.


When you buy Berkshire you are banking on Buffett’s integrity. The guy doesn’t have to be a saint, but he does have to be a halfway decent human being. He controls the company and conducts complex transactions on both the investment and insurance side.


Trust has always been required of those who invested alongside Buffett. In his early partnership days, his disclosures were next to nil, investors’ money was locked up until year-end, and they were putting their trust in a slightly odd young man who worked from home. Those were the ground rules. And they turned some people off. The rest got rich.


If you don’t trust Buffett, don’t buy Berkshire, and don’t believe anything about these derivatives contracts.


Me?


I trust the guy. I’m probably biased. But I’m also probably right.



A Good Bet


Also, I have to admit, if I were running Berkshire and was offered a deal to sell those puts on the terms Buffett did, I would take it.


There is a difference between a good bet and a winning bet. A bet is good when the odds are in your favor and your bankroll can bear the full brunt of an utter and unpredictable loss. A bet is winning when you win. Most people judge themselves on outcomes. That’s insane. You can’t control outcomes. Only process.


Buffett once wrote:

"You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”

Those words were written 47 years ago – before Berkshire, before the insurance business – before everything but Graham’s training and Buffett’s rationality.


I don’t know if Buffett will lose this bet. But I do know his style hasn’t drifted an inch.


Geoff Gannon

www.gannononinvesting.com