Thursday, November 20, 2008

Is Buffett Worried? No, but Somebody Is

Warren Buffett professes never to worry about a position, even if it’s down 50%.

Since he never strays outside his famous “circle of competence,” except maybe for that US Air investment a few years back, Buffett figures he knows more than the market thinks it does, manic-depressive as that market tends to be. “You use the market to serve you and not to instruct you,” he told one young investor from India at the Berkshire annual meeting this year.

So the odds are good that Buffett himself is not breaking a sweat over his own stock’s 40% decline since his late September cavalry-to-the-rescue investment in Goldman Sachs.

After all, who knows more about Berkshire than Warren Buffett?

Still, somebody out there is indeed breaking a sweat about Berkshire, and not just the company's stock. Credit default swaps in Berkshire—insurance against a default by Berkshire—have been climbing ever since the market began its September swoon, and suddenly spiked in the last few days.

Specifically, the Berkshire 5-year CDS began the month of September at about 100, climbed to just over 250 a week ago, and cruised to 481.7 yesterday, according to our Bloomberg. (This means somebody was paying $481,700 annually to insure against a default on $10 million of debt for five years.)

Why does this matter?

Well, credit defaults swaps have been an excellent early warning indicator of trouble at nearly every financial company that now no longer exists in their previous forms. And the reason is quite simple: companies doing business with highly leveraged financials can buy credit default swaps in those financials in order to hedge the risk of a collapse.

This is exactly what happened with AIG. According to the recent, excellent Wall Street Journal account of AIG’s final days, Goldman Sachs reportedly was buying credit default swaps in AIG to hedge their counterparty risk well before that firm hit the wall. So by keeping an eye on movements in credit default swaps, shareholders get a good look at where the bond market thinks the company is going.

And in the case of Berkshire, the bond market is worried.

Most strikingly, Triple A-rated Berkshire’s CDS are trading higher than several considerably lesser lights in the insurance realm, including Allstate (301.7), Progressive (252.3) and Odyssey Re (158.3).

Which begs the question, who is buying credit default swaps in Berkshire Hathaway, and why?

Taking the last question first, the most obvious reason is Berkshire’s heavy exposure to derivatives, particularly the $37 billion notional value stock market put options Buffett sold for nearly $5 billion when the world markets were substantially higher than today, and on which Berkshire has taken mark-to-market losses of nearly $2 billion already.

In addition to the market index puts, there is another $11 billion in notional value worth of credit default obligations on Berkshire's books.

All told, Berkshire entered the crisis with nearly $50 billion of theoretical derivative exposure. This may seem ironic, given Buffett’s early warnings against derivatives as an asset class (“ticking time-bombs,” he called them five years ago), but Buffett is no shrinking violet when it comes to making money off whatever comes his way that fits in that circle of competence of his. “We have at least 60 derivatives,” he told shareholders two years ago, “and believe me: we’ll make money on all of them.” And his shareholders believed him.

But somebody, now, does not.

Who might that somebody be? For starters, the firms (insurance companies, most likely) who purchased those index puts from Berkshire might be getting nervous that, since the crisis has not let up, they should hedge their exposure to Berkshire.

Or it might be insurance companies that have purchased reinsurance from Berkshire (Berkshire does a huge business in catastrophic reinsurance—hurricanes and such), hedging their exposure in case the “Oracle of Omaha” suddenly loses his touch.

Time will tell if Mr. Market is instructing us, or not.

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.


Adam J Davis said...

Great post and great information. Time will only tell how Buffett's positions will pan out. However...

His advantage is a strong and growing capital base (many cash flowing sub. companies) and a decidedly focused approach against the "smart money" that is betting against him. BRK, like a double-hulled ship, can take a few shots and keep heading straight.

It would seem that the institutional managers taking the other side can't "get fired" for buying this type of insurance. Although, as a whole, many of these institutions haven't really had a hot streak to speak of recently.

Anonymous said...

rumor is hedgies were going long Sr Secured bank debt and short BRK. Not sure if I understand that but its moving. good note

Dan E said...

The reason I read this blog, in addition to the odd tale of unhelpful stock calls, is for your $.02. This is a neat story about the activity in Berkshire, but I'd appreciate it more with your opinion in it. Especially given all the homework I'm sure you've recently done on Berkshire and WB.

Jeff Matthews said...

Dan, I never give opinions on stocks, if that's what you're asking for. Never have, never will.

Assuming your asking my opinion on what's really going on...for what it's worth, seems likely to be real buying by Berkshire counterparties, not speculators betting on the S&P going to zero by the year 2019 (when the index options start maturing) and Berkshire getting stuck with a $50 billion write-off.

But more informed opinion is welcome.


Anonymous said...

Jeff - in this market crowded "safe" stocks are getting killed. I would bet 99% of the holders are long BRK due to WB and CM and the past track record and trust them but what about holders who need liquidity? Fido could trim 1k shares a day and raise some cash not denting the 25k they hold but the absence of buyers in this tape could see BRK closer to 5000 vs 10000 fairly easily. And think if others trimed 100 shares too a day - plenty of those types of holders too. My point is that WB might be faced with a lack of buyers for BRK as I was told a few years back "don't be shocked to see someone ask for their money back from your fund...when you never could have imagined they needed money." I'd be a seller...

Dan E said...

Good point about not recommending stocks. I hadn't thought about it that way, but I can see how a comment on a change in value could be taken as your endorsement to sell/buy. I guess what I was looking for was your opinion on Buffett's derivative investment (smart / foolish / don't know). But again, I can see now how that might be seen as a vote for/against Berkshire, so understood if that's off limits.

whydibuy said...

And maybe is a sign of the intense panic sweeping the markets over anything other than a treasury. If I recall, those S&P options were very long term, 15 or twenty years and they were European options; exercisable only at maturity. No chance of a early call and the mark to market is a non cash accounting adjustment. Buffett hasn't lost a dime and is earning on the float from the put premiums. Yes, hes playing history that says no one ever lost money on stocks over a 7 year period but today past history is no guarantee of future performance. As we're seeing.

Anonymous said...

I really wondered for a long time why Buffett bought that stake in GS. Sure, Goldman is the best choice in financials, but everybody could make that choice, that's not a real WB pick. He got favorable terms, sure - but only time will tell if good enough.
So I came to the conclusion that this is just a planned loss before Congress and US citizens start turning towards him: "Hey, you are drowning in liquidity! I think we need to force you to invest into some companies that WE choose..."
Now WB can say: "Hey I tried but it didn't work either..."

Jack Straw said...

Pandit's comments came during a morning conference call with his staff. During the call, Pandit said "rumor mongering is at the heart of our problems," and he reiterated that Citigroup's capital position is very strong.

How come whenever a company is going down, some type of "rumor mongering" is always the first excuse a CEO comes up with? Yeah Vikram, I'm sure this is all just a bad game of telephone.

Anonymous said...

One potential thought on the Goldman investment is Goldman was Berkshire's main "prime broker" if there is such a thing for them, where they structured this derrivatives contract, among other things. Perhaps Buffett had some self-interest in keeping Goldman around; not sure where the company holds its securities, but if I had to guess I'd say Goldman.

As for the CDS blowout, perhaps this a contrarian indicator that we are in the depths of fear and irrationality. In my view, Berkshire is more credit worthy than the U.S. government.

Anonymous said...

While your comment about negative CDS activity in companies that have subsequently failed was interesting, I think it is also misleading in implying it has predictive value. You only mention the failures this activity predicted but you do not mention any negative CDS activity that did not accurately predict failure. How many firms expreienced negative activity but then did not fail or thereafter experienced a recovery in CDS outlook? Don't ask me, though, I am too lazy to do the actual work...just wondering if you did.

Jeff Matthews said...

"Rational" raises a good question, and the answer is, "very few" financials have survived serious, sustained spikes in their credit fault swaps.

Morgan Stanley is the most dramatic example of a company surviving a CDS warning signal, thus far: the MS CDS blew out to 1,200 in early October before collapsing back to the 400 level...although they have recently spiked to 531.7.

Still, MS equity is well below its levels during the halcyon, pre-CDS spike days.


invstmnt said...

This post is on May 4, 2009.

Warren Buffett gave you, at Saturday's shareholder meeting, the answer to your speculation about the equity puts being the possible cause of the CDS activity.

He said that as the market was dropping and Berkshire's written puts were increasing in value, the counterparty had to by more CDS on Berkshire to insure further the unrealized gain against credit risk of Berkshire not being able to pay.

Very curious when one considers that Berkshire probably has a better credit picture than the other side of the CDS the counterparty used.