Wednesday, September 24, 2008

The “Oracle” Speaks: Listen Up, Hank

During the depths of the AIG crisis, which seemed like it was six years ago but was, in fact, early last week, we were contacted by a reporter who wondered if Warren Buffett would say something reassuring about the U.S. economy to help calm down the panic on Wall Street.

We pointed out that Buffett is, first and foremost, a money-maker. He is not a public treasure—although his shareholders treat him that way—to be trotted out on occasion to make pronouncements about the health of the country, as Old Man Rockefeller did back in 1929.

If Buffett was in fact going to do anything, we ventured, it would be to search for opportunities in the market freeze-up just as he had done in January and February of this year, when he bought $4 billion worth of auction-rate securities while those went into free-fall.

We said the world would only hear from Buffett after he pulled the trigger—not before.

Well, last night we heard from Buffett.

And what we heard was that “The Oracle of Omaha” is buying $5 billion worth of preferred shares in Goldman Sachs that carry a 10% dividend, and along with those he’s buying warrants for $5 billion worth of Goldman stock at $115 a share.

Last trade, $133.

It’s a classic Buffett deal: he's buying into a great company at a distressed price, with unbelievably good terms.

Now, Warren Buffett might be called “The Oracle of Omaha,” but he is not, in our opinion, an “Oracle.” (We explain why in “Pilgrimage to Warren Buffett’s Omaha,” coming soon to a bookstore near you.)

Still, oracle or not, Buffett is worth listening to.

And with this $5 billion-plus investment in Goldman Sachs, he is speaking loudly and—we think—quite clearly.

What we think he’s saying is that the $700 billion bailout plan being pushed down the country’s throat by Hank Paulson and Ben Bernanke—two men who both had seats at the bar while the lethal subprime mortgage cocktail was being concocted by Wall Street—is for the birds.

Sure, Buffett’s telling CNBC this morning that without the Paulson/Bernanke plan he might not be making this investment. And yes, he’s saying a Paulson/Bernanke plan would keep us from going over the edge.

But what else might you expect a man whose company, Berkshire Hathaway, has sold S&P Index put options with a notional value of $39.878 billion dollars as of June 30, 2008, to say?

As is always the case with Warren Buffett, it pays to look at what he’s doing—not what he’s telling CNBC.

And what he’s doing is not what the U.S. Treasury wants to do with Goldman’s sick brethren: he is not buying Goldman’s “bad” assets.

He is, instead, buying preferred shares with a nice fat yield.

Second, he is getting warrants to buy Goldman stock in order to capture whatever upside that his stability-inducing investment helps foster while Goldman adjusts to being a bank holding company.

Paulson and Bernanke seem to have had no such notions in their heads.

Their plan was to buy $700 billion of whatever junk got thrown at them by men in pinstripes who got paid very, very well for many, many years while they made some very, very bad decisions they now regret.

We wonder what else Paulson and Bernanke will want to buy to prop up the system: old, expired lottery tickets, perhaps?

More seriously, we wonder this: how is it that Warren Buffett can cut a better deal with the best-run financial company in America than the U.S. Treasury can ask from the worst-run financial companies in America?

Jeff Matthews
I Am Not Making This Up

© 2008 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.


Anonymous said...

terrific post!! maybe without the endless procession of bailouts the private market could work properly as in the case of GS/Buffett.

Mark B. Spiegel said...

While it *is* a ridiculously sweet deal for Buffett (Good for him! He deserves it for being smart enough to still have the ability to write that kind of check these days), it must mean something (good for his opinion re. the value of Goldman) that he was willing to (presumably) rank relatively low in the company's cap structure (just above the common), and that he was willing to strike his warrants as high as $115, which would seem to indicate (unless he's already hedged against them somehow) that he still sees substantial value in the equity component of the company. Personally, I think he's somewhat wrong, as a substantially less-leveraged Goldman will be substantially less of an "earnings machine" going forward, and I thus see its common stock settling in at a value that's well under $100/share for a very long time. But then, Warren is Warren, and I'm just me.

Unknown said...

amen brother

Anonymous said...

I don't know about that...its starting to look like the government got a sweet deal for AIG.

Anonymous said...

"how is it that Warren Buffett can cut a better deal with the best-run financial company in America than the U.S. Treasury can ask from the worst-run financial companies in America?" Because incentives matter?

Anonymous said...

That last paragraph is priceless.

Anonymous said...

Umm... because Buffett's a capitalist, and the government's the government.

Anonymous said...

I'm ignat on this point:

"But what else might you expect a man whose company, Berkshire Hathaway, has sold S&P Index put options with a notional value of $39.878 billion dollars as of June 30, 2008, to say?"

So, a few questions:
- Where does this data come from?
- Are those the current puts he owns, or an aggregate of his actions over some period of time?
- By selling puts, he's betting the market will go up - so are you saying he bought the bank positioned for a rally?

Can anyone help me out?

Adam said...

Goldman did the deal because it's at better terms than the government has been offering. And they knew that they'd have to raise capital sooner or later.

Their bailout strings have been 80% of the firm and the cessation of dividends for common and preferred shareholders. The latter pretty much ended any chance of issuing preferred on the private markets.
Look at the prices or yields on preferred stock following the Freddie and Fannie take over (there's much too much risk for most typical preferred shareholders to accept).

Adam said...

anon 2:32
Buffett's annual report a few years ago mentioned the transaction. Writing puts means that you agree to buy something (in this case shares in the S&P 500 constituent firms) at a pre-arranged price during a given time, but the potential seller doesn't have to sell if they choose not to sell. Buffett's puts wouldn't benefit if the market rises, but he'd lose money if it declines (why do you think he's all in favor of the plan).

I'm not sure he's ever made a public pronouncment that wasn't aimed at directly benefitting his firm.

Pamela said...

OHHH Buffet has a conflict of interest because he wants to the US to succeed...we have proof as he put money on it!

I guess the alternative is that you don't want it to succeed...and maybe thats true if your name is Hugo Chavez or Mahmoud Ahmajinidad.

If you live in the us and rely on its financial system, you're effectively short puts or long calls on its economic success, whether you like it or not.

Lucas Price said...

Hi Jeff,
1st time reader of your blog. I don't follow buffet closely, but I am very interested in your comment about he notational value of puts that he owns. How is notational value calculated? Is that the dollars he received for selling the puts? or is the the strike price times the number of shares optioned? Is there anyway to know what strike price they were sold at, how much they were sold for, expiration date of the puts, number of options sold, etc?

Anonymous said...

my understanding on the berkshire puts is they are mostly insurance, meaning deeply out of the money. so while a flat result would be fine for berkshire, a collapse wouldnt

cadamyale said...

If I remember correctly, these are long-dated puts that are not exercisable until the strike date. Inflation alone should put the S&P above the strike price.

sugam said...

Hi Jeff, I am a new reader and love your posts. But it would be beneficial to us if the source to the puts on S&P be posted so that we can also make accurate judgments and digest the facts :) ( feels difficult to believe that a guy like buffet will undergo derivatives transaction of such a magnitude .. that too something that is a pure speculative market bet with no upside potential )

Anonymous said...

The answer to your question is that Buffett can pull this deal off because he is, simultaneous with his investment, selling Goldman the Warren Buffett Seal of Financial Stability. Apparently, it's worth several billion dollars to GS at this moment. The US Treasury & Fed, for all the reasons you mentioned above and having just purchased loads of terrible assets, has no such Seal to sell.

Anonymous said...

The reason Buffett could pull this deal off is that, concurrent with his investment, he is selling Goldman his Warren Buffett Seal of Financial Stability. This is worth several billion to GS at the moment, apparently.

On the other hand, given their actions and recent investments/bailouts, the US Treasury has no similar Seal to sell.

Lucas Price said...

if you were using puts for insurance, wouldn't you typically buy them, not sell them?

Anonymous said...

So, I guess one could take away that book value and dividends still matter, especially for financial firms like GS where it has a valuable brand name (i.e., franchise) run by competent managers such as CEO Lloyd Blankfein. Dang, Buffett's shrewd!

Anonymous said...

Lest you forget to mention that Buffett directly benefited from his discounted purchase of CEG, which was facilitated by this liquidity crisis. Now that the acquisition agreement has been signed, it is time for the government to issue a "cease and desist" order on the liquidity crisis, no?

Also, doesn't GenRe need all their derivative counterparties to stay whole to survive?

Hayseed said...

GS investment sounds to me like a bond and a hedge through option upside. Once again, the Oracle gets something the average guy can't get (though he professes to be the average guy). Kind of like his playing the income and death tax card to raise taxes on the people who pay almost all of the taxes, while he sets up aggressive tax-advantaged vehicles for himself. Or maybe like his ad infinitum harping that derivatives are bad, while holding such derivatives, and now selling puts. And maybe this time, his quasi-positive bet on the US will work... recall he got torched on his negative currency bet against the US a few years back, unwinding his position at exactly the wrong time, right before the dollar imploded.

Unknown said...

You bring clarity to an uncertain and very obscure world, thank you.

Jeff Matthews said...

Readers looking for details on Berkshire's Index Put position can go to the company's web site and review the 10Q and 10K filings.

It's all there.


The Daily Pander said...

Allow me a brief comment on BRK's put contracts (I'm a recovering options market maker, BTW). Buffet sold very long-dated at-the-money puts on the S&P and two other indexes, one foreign the other domestic. All three trades will settle in cash, not in securities so BRK is only obligated to deliver the difference between the strike price and the settlement price. What makes these trades so deliciously beautiful for BRK is that there's no counterparty risk (BRK holds the cash in ITS bank account) and the option can only be exercised on the expiration date (that's called a European style option. One that can be exercised in advance of expiration is called an American style option). BRK will be earning interest on the cash for close to 15-20 years. Without knowing the actual strike price and the actual expiration date and the initial premium for the contract, I can only speculate on the breakeven point, but a little back of the envelope calculating bears out that the germaine indexes would have to be trading at or near zero in 20 years for BRK to lose money. I like that bet. I like it a lot.

Anonymous said...

This just in from NYT,

Talks Implode During Day of Chaos; Fate of Bailout Plan Remains Unresolved

Maybe there is still a chance for this garbage to be shot down.

Tahoe Kid said...

What is interesting about the investment is Buffett gets a 10% yield on a Goldman Perp. Preferred. Bill Gross (per NY Times story) passed on the opportunity to buy a Morgan Stanley pece of debt maturing in 6 months yielding 25% (not a typo).

“We were offered this morning a six-month sizable piece of Morgan Stanley,” he said on Tuesday. “Here’s the surviving investment bank that just last night got equitized or bailed out by a Japanese bank. We were offered a sizable piece of a six-month Morgan Stanley obligation at a yield of 25 percent, O.K.?”

Pimco did not buy the bonds, “because we thought we could get it even cheaper,” Mr. Gross said, adding that thinking of that kind was at the heart of today’s market paralysis."

Two very different views withen 24 hours of each other on two firms with similar financial profiles. Gross may have been too pricey or Buffett may have been too much of a pushover. Time will tell.

One last thought: If Goldman should need a bailout by the Treasury, would Paulson torch the existing Goldman preferreds including Buffett? Not that I would wish that on anyone given what we are seeing these days.