Omaha, NB - "In a surprise move, Warren Buffett has replaced the much-maligned derivatives contracts he wrote last year, with insurance policies written on a variety of equity indexes. Doug Kass, who has been one of the most vocal critics of said derivatives (European put options that Buffett wrote on a variety of equity indices) declared that his accusations of "style drift" have been vindicated by Buffett's surprise move. Now, instead of receiving a premium up front in return for assuming a risk that said indices decline to levels below 2008 levels by the end date of the contracts 15-20 years from now, Buffett has now received a premium up front in return for assuming a risk that said indices decline to levels below 2008 levels by the end date of the..." Hey... wait a minute!
Get the point (Doug)? Buffett's short puts are nothing new for him, and do not represent style drift. They are simply insurance policies that Buffett was willing to write in return for $4.9B received up front. Much like an insurance risk, Buffett knows his maximum loss, and knows how much in premium he will receive. Even better than an insurance policy, he knows the date of any potential liability.
Buffett is all about float, and these puts are no different. He has $4.9B to play with for 15-20 years. His maximum loss, assuming ALL STOCK INDICES GO to ZERO, is $37.1B, 15-20 years from now. Now, somehow, I think if all the indices are worth zero in 15-20 years, we will all have much bigger problems (like wishing we had spent more time studying the Mad Max movies for survival tips).
Let's do the exercise anyway. I am just going to assume a 37.1B liability in 17.5 years. Present value at 3% inflation (3% - yeah right!)? $18.7B. Subtract the $4.9B premium, and you get $13.8B. That's alot, but Buffett can afford it. We did forget to multiply that scenario - which I tend to think is a wee bit unlikely - by a probability. What is the probability that ALL the INDICES are WORTH ZERO in 15-20 years? 50%? Then you better start Mad-Max-ing. How about 26%? A 2.6 in 10 chance? Not likely either, but let's use it (because the math works). Then the expected value is -0-. Any lower probability than that (which anyone except maybe Roubini would undoubtedly assign that scenario) and the expected value is positive!
Or, we can flip it around. Again, Buffett has $4.9B in cold, hard float today. We have already seen that Buffett can easily loan cold hard float to quality companies at a 10-15% coupon. Let's haircut that though and say he can only earn 6%. His 4.9B will magically float its way up to $16B. To lose that much on the puts in 15-20 years from now, the equity indices will have to be at levels 43% below those when the contracts were written. Not impossible, but certainly not likely.
We can play around with these scenarios all day. Well guess what - I'm sure Buffett and Ajit Jain "played" for much longer, and are more than fully aware of the risks. They do this stuff all day in the insurance markets with much more difficult-to-quantify risks. And their long term record, as measured by their combined ratio of <100 (i.e., they have been paid to play with other people's money), has been stellar. As Buffett wrote in his recently released letter, "Ajit's business features very large transactions, incredible speed of execution and a willingness to quote on policies that leave others scratching their heads."
When writing these puts, Buffett was doing nothing more than taking advantage of a "hard market" in stock market insurance. "Hard market" in the insurance biz means hefty premiums. As Buffett outlines in his annual letter, "stock market insurance premiums" are determined by the Black-Scholes model, which is heavily influenced by recent market volatility trends. So if the market is very volatile, you'll get paid much more to write insurance on it - even if you know that the possible payout is decades away. This is somewhat akin to a natural disaster causing insurance premiums to rise, even though a recent disaster may imply nothing new about the likelihood of a future disaster. Recent market volatility, although huge, may imply nothing new about long term market volatility, and thus implies nothing new about the far-future probability of a market disaster (and hence a payout by Berkshire on the puts).
Sure, one mildly unpleasant by-product of these market insurance contracts (short puts) is that unlike standard insurance contracts, they must be marked to market quarterly. Once again, the "mark" is determined by Black-Scholes for lack of a better method. At present, these contracts show a huge non-cash accounting loss. Who cares? No more cash will change hands until 2025 and beyond. Yet each quarter, Berkshire must take an accounting loss or gain based on what Black-Scholes "thinks" the present value of the contracts are. These marks should be of little concern to Berkshire investors, since they are simply a "guess" about the puts' value which will not truly be known for decades, and little if any collateral is required of Berkshire against the marks in the meantime.
Style drift? Bunk! My prediction: Buffett will make Berkshire shareholders billions with these "market insurance policies" - we just won't know for sure for a long time, and he may not be around to see them expire worthless. In the meantime, we can watch the $4.9B grow.
Disclosure: Long BRK.B
Todd Kenyon
www.investorwalk.com
Get the point (Doug)? Buffett's short puts are nothing new for him, and do not represent style drift. They are simply insurance policies that Buffett was willing to write in return for $4.9B received up front. Much like an insurance risk, Buffett knows his maximum loss, and knows how much in premium he will receive. Even better than an insurance policy, he knows the date of any potential liability.
Buffett is all about float, and these puts are no different. He has $4.9B to play with for 15-20 years. His maximum loss, assuming ALL STOCK INDICES GO to ZERO, is $37.1B, 15-20 years from now. Now, somehow, I think if all the indices are worth zero in 15-20 years, we will all have much bigger problems (like wishing we had spent more time studying the Mad Max movies for survival tips).
Let's do the exercise anyway. I am just going to assume a 37.1B liability in 17.5 years. Present value at 3% inflation (3% - yeah right!)? $18.7B. Subtract the $4.9B premium, and you get $13.8B. That's alot, but Buffett can afford it. We did forget to multiply that scenario - which I tend to think is a wee bit unlikely - by a probability. What is the probability that ALL the INDICES are WORTH ZERO in 15-20 years? 50%? Then you better start Mad-Max-ing. How about 26%? A 2.6 in 10 chance? Not likely either, but let's use it (because the math works). Then the expected value is -0-. Any lower probability than that (which anyone except maybe Roubini would undoubtedly assign that scenario) and the expected value is positive!
Or, we can flip it around. Again, Buffett has $4.9B in cold, hard float today. We have already seen that Buffett can easily loan cold hard float to quality companies at a 10-15% coupon. Let's haircut that though and say he can only earn 6%. His 4.9B will magically float its way up to $16B. To lose that much on the puts in 15-20 years from now, the equity indices will have to be at levels 43% below those when the contracts were written. Not impossible, but certainly not likely.
We can play around with these scenarios all day. Well guess what - I'm sure Buffett and Ajit Jain "played" for much longer, and are more than fully aware of the risks. They do this stuff all day in the insurance markets with much more difficult-to-quantify risks. And their long term record, as measured by their combined ratio of <100 (i.e., they have been paid to play with other people's money), has been stellar. As Buffett wrote in his recently released letter, "Ajit's business features very large transactions, incredible speed of execution and a willingness to quote on policies that leave others scratching their heads."
When writing these puts, Buffett was doing nothing more than taking advantage of a "hard market" in stock market insurance. "Hard market" in the insurance biz means hefty premiums. As Buffett outlines in his annual letter, "stock market insurance premiums" are determined by the Black-Scholes model, which is heavily influenced by recent market volatility trends. So if the market is very volatile, you'll get paid much more to write insurance on it - even if you know that the possible payout is decades away. This is somewhat akin to a natural disaster causing insurance premiums to rise, even though a recent disaster may imply nothing new about the likelihood of a future disaster. Recent market volatility, although huge, may imply nothing new about long term market volatility, and thus implies nothing new about the far-future probability of a market disaster (and hence a payout by Berkshire on the puts).
Sure, one mildly unpleasant by-product of these market insurance contracts (short puts) is that unlike standard insurance contracts, they must be marked to market quarterly. Once again, the "mark" is determined by Black-Scholes for lack of a better method. At present, these contracts show a huge non-cash accounting loss. Who cares? No more cash will change hands until 2025 and beyond. Yet each quarter, Berkshire must take an accounting loss or gain based on what Black-Scholes "thinks" the present value of the contracts are. These marks should be of little concern to Berkshire investors, since they are simply a "guess" about the puts' value which will not truly be known for decades, and little if any collateral is required of Berkshire against the marks in the meantime.
Style drift? Bunk! My prediction: Buffett will make Berkshire shareholders billions with these "market insurance policies" - we just won't know for sure for a long time, and he may not be around to see them expire worthless. In the meantime, we can watch the $4.9B grow.
Disclosure: Long BRK.B
Todd Kenyon
www.investorwalk.com
