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Andrew Mickey
Todd Kenyon
Articles (5983) 

Berkshire Hathaway's Warren Buffett Closes Derivatives Contracts - Goes Back to Writing Insurance!

March 04, 2009 | About:

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


Rating: 4.3/5 (20 votes)

Comments

zapzappa123
Zapzappa123 - 12 years ago    Report SPAM
So what your saying the strike prices on these are "all indices go to zero"

Sure, who wouldnt want to write those puts but thats not the case now is it.

What are the strike prices on these puts, because Buffet could easily be out the 4.9b if they are ever in the money
zapzappa123
Zapzappa123 - 12 years ago    Report SPAM
By the way if all the indices are worth zero, whats BRK going to be worth.


hahahahaha
alanb9
Alanb9 premium member - 12 years ago
zapzappa123,

If I understand your post, you don't understand Berkshire's derivative position.

Do yourself a favor, if you really want to understand Berkshire's derivative positions, and go to their website (www.berkshirehathaway.com) and read his letter to shareholders. He goes in much detail about his derivative position.
doubleh
Doubleh - 12 years ago    Report SPAM
Can anyone believe this?

http://www.cnbc.com/id/29515672

SEC should stop everything they're doing and start investigating who's buying these CDS. They'll find the same crooks shorting BRK equity as well.
spasm
Spasm - 12 years ago    Report SPAM
My understanding of this is that Warren Buffett is given $4.9B cash up front for 15 years. Assuming a worst case scenario of losing $37.1B in 15 years, Buffett would need to compound that $4.9B at an approximate annual compounded rate of 14%. His long term compounded returns are at about 20% although it has been more like 10% in the last 10 years.

I think this deal would best be analysed as a series of in built margin of safety filters.

Firstly, the probability of the S&P 500 going to zero is very slim. If he put all the $4.9B in 15-year treasuries, it would be $7.63B. He would have lost $29.47B. A loss like that would be painful but not fatal to Berkshire. I have to stress this as a highly unlikely event.

In a second scenario, even if the S&P is lower in 15 years than they are at these levels, Buffett will pay a reduced insurance settlement (in proportion to the drop in the index).

Under these set of circumstances (i.e. the S&P is lower than their levels now but more than 0 in 15 years) the annual compound rate that Buffett much achieve is much lower than 14% to break even. In which case he would have generated negative float but may nonetheless have generated positive investment returns if the cost of float was not too expensive. For example, if in 15 years the S&P is half of where it is now, he would need 9.44% compounded returns on that $4.9B to break even. This 9.44% would be his cost of float, if he made 15% on his investments he would be in the money.

The reason for highlighting this scenario is that it did happen once in the great depression and ONLY if you made this kind of deal near the peak. It is quite a stretch to argue that at the time he made this deal, the market was near its peak.

The third and most likely scenario is that the S&P 500 will be be higher 15 years from the level where Buffett made this deal. If so, his cost of float is basically 0% which means someone gave him cash to invest virtually for free.

This is my take on what he reported. If you found this useful or if you found this lacking please let me know.

I have no position in berkshire at this present time.

zapzappa123
Zapzappa123 - 12 years ago    Report SPAM
Spasm

Why are you guys making this overcomplex, and why are you analyzing based on a premise of indices falling to zero, if the indices fall to zero BRK will be bankrupt like everyone else so why bother compounding premium money using a scenario like that.

I assume these are puts or cds swap, so the question is..

What is the strike price and at what point do they go into the money?

From there you may be able to determine what risks BRK is taking on.

ALL CDS swap positions should be flattened and the use of them outlawed, why should the entire world be threatened by this massive systemic risk merely because the thumbsuckers and toddlers on Wall Street cannot ride their positions out like the rest of us and insist on buying this idiot insurance, that if it ever actually had to pay off, could never, due to the massive counter party risks involved (CDS swaps on US debt default for instance)

Why is Buffett participating in this sham market?
zapzappa123
Zapzappa123 - 12 years ago    Report SPAM
OK got it, I see what you are saying....from the letter

"The contracts, which insure against stock market declines over a period of many years, total $37.1 billion. They're written against the S&P 500, the U.K.'s FTSE 100, the Euro Stoxx 50 in Europe, and Japan's Nikkei 225.

Berkshire is only required to make any payments when the contracts expire. The first comes due in 2019 and the last in 2028. The mark-to-market, or 'paper', loss on the equity put contracts totals $5.1 billion.

Buffett emphasizes a point that he says is often misunderstood. "For us to lose the full $37.1 billion we have at risk, all stocks in all four indices would have to go to zero on their various termination dates." If the indices are down 25 percent, Berkshire would owe about $9 billion between 2019 and 2028, and would have had use of the $4.9 billion premium all along.

Buffett's conclusion: "We have told you before that our derivative contracts, subject as they are to mark-to-market accounting, will produce wild swings in the earnings we report. The ups and downs neither cheer nor bother Charlie (Munger) and me. Indeed, the 'downs' can be helpful in that they give us an opportunity to expand a position on favorable terms. I hope this explanation of our dealers will lead you to think similarly."
batbeer2
Batbeer2 premium member - 12 years ago
Just an idea....

1) If the S&P is at 0, who will be around to collect that 40B ?

2) What would be the fair value of the company having that right ?

IMO this is a typical example of the long term investor KNOWING he cannot lose in the end while the traders are betting on the price changes and hope to make some money along the way by correctly applying the greater fool theory and/or outsmarting other traders.

Amazing to see that someone is willing to part with cash, giving the cash to BRK in return for some complex `asset`.
batbeer2
Batbeer2 premium member - 12 years ago
....I'm sure Buffett and Ajit Jain "played" for much longer, and are more than fully aware of the risks....


I wouldn´t be to sure about that. I think WEB needs less than 5 minutes to arrive at the minimum premium for this insurance policy and Ajit would be busy getting a hamburger for the man for 4 of those minutes after having arrived at a number within 5% of WEBs number within 1.2 minutes.

So they multiply their highest estimate by seven and close the deal with an idiot who needed a week to read the report on why the policy was needed in the first place.
gembree
Gembree - 12 years ago    Report SPAM
That a CDS on Berkshire Hathaway costs the same as a CDS on a junk bond is truly amazing. Makes me wish I could write them myself, although Berkshire itself at $2400 is enough of a bargain.
adamcz
Adamcz - 12 years ago    Report SPAM
Batbeer has it right - Buffett almost certainly didn't have to do much thinking about this deal - he has already spent years of his life thinking about the longterm direction of markets, the effects of inflation, the effects of population growth, etc.

This deal smelled like insurance to me from the very beginning, so I was always astounded to hear people say that Buffett was sufferring "style drift."

In a world where all major indicies are worth zero, there is no capitalism at all. If you can't own businesses in this future world, you probalby don't have the same need for money that you have today, and shouldn't be so concerned about losing it in derivatives. Probably the state rations out your food and clothing anyway, and you live underground in a complex tunnel system.

There is real money at stake, but it isn't 37B.
brka275
Brka275 - 12 years ago    Report SPAM
Reading all of your posts got me thinking, An index has never fallen to zero because as time passes and companies fail or are not meeting the indexes criteria, they are replaced with a newer more up to date member. Ex: The U.S.steel industry is all but history, replaced by Microsoft, McDonalds, Home Depot etc. So in fifteen or twenty years the composition of each index may be different and not put the contract in jepordy where Berkshire has to pay out.
adamcz
Adamcz - 12 years ago    Report SPAM
Even if every business did fail without being replaced in the index, it still wouldn't hit zero. There would be some value on the books that I personally would be willing to pay for.

The only way it hits zero is if we convert to a strong form of communism that bars me from bidding three penies for all of microsoft.

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