We couldn't help but snicker a bit at the news, reported via Bloomberg, that Berkshire Hathaway CDS costs have "almost tripled in two months." Bloomberg attributes the soaring CDS quote to a series of equity index puts Berkshire wrote some time ago. The puts have attracted a great deal of attention almost since their original sale, partly because of Buffett's often quoted (and seemingly hypocritical) analogy putting derivatives in the "financial weapons of mass destruction" category. (We picture Brooks Brothers clad Femmebots holding suitcases filled with cash and shooting fire from their perfectly shaped breasts while intoning "Here's your liquidity. Here's your liquidity." in robotic-monotones).
As far back as February, Barron's suggested that those puts could show losses as high as $2 billion in the third quarter. Their near $7 billion paper liability at present would be a painful surprise to anyone relying on Barron's estimates, if the puts were really capable of inflicting much pain on Berkshire at this point. They aren't.
In some way, Buffett's genius (to the extent it exists) is not directionally perfect trading, not calling the top or the bottom, but cutting amazing deals that no one else would likely ask for, much less get, outside of the "covenant lite" days of LBO lending.
In Buffett's shareholder letter from 2007, he discussed the instruments:
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 year end of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, 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.Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.
Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire's balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings - even though they could easily amount to $1 billion or more in a quarter - and we hope you won't be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.
These are anything but standard option contracts. When the deal was cut, Berkshire had written European style put options, penned at then at-market strikes with 15-20 year expiration dates, with very restricted margin call requirements. Apparently, mark-to-market or fair value accounting adjustments don't trigger any requirement for Berkshire to post additional collateral. Though the text of the contracts are not public, it seems that only Berkshire credit downgrades would trigger collateral requirements.
If these facts are correct, Berkshire has, therefore, managed to obtain the use of $4.5 billion in cash and will pay nothing between now and 2019 unless it faces a severe credit downgrade, and will pay nothing after 2019 unless three equity indexes including the S&P 500 are trading lower than their 2004-2006 levels. To put it in perspective, the S&P 500 would have to be trading at under 300-500 today for similar puts to expire in the money. In a way this looks like writing CDS protection on Treasury instruments. If they actually come due you have problems so much more significant than paying the put off that you wonder if you are ever going to have to come up with the cash (rather than find a sharper stick with which to stab the rabid tiger that has escaped the local zoo and feed your warrior clan for the next week in order to be strong enough to fight off roving bands of the Lord Humongous).
Also, and not to put too fine a point on it, will the Sage even be around when these come due?
Berhshire's five year average return on equity floats around 10.5%. This isn't a perfect return number to apply, and even the Sage admits he can't continue the outstanding returns he is famous for, but $4.5 billion with that kind of a return over 15-20 years should fetch between $20 and $33 billion.
In short, it's hard to understand why CDS protection would spike like that over a non-cash derivative liability's short term swings. Or, maybe, CDS traders are looking at something else all together more sinister. Berkshire also has written a number of CDS contracts, though their notional amount is substantially lower. Bloomberg doesn't delve into these in detail, but they also think that the fact that Barack Obama seeks Warren out for economic advice is a reason to think that the puts will expire worthless, so who knows what the hell they are thinking.
Berkshire's Credit Risk Soars on $37 Billion Bet [Bloomberg]
Posted by guest , Nov 19, 2008 1:53PM
Warren is a horny man in whorehouse. You can short him all you want but his boner is still harder than peter north on viagra.
Posted by guest , Nov 19, 2008 1:56PM
Where can I meet some of these aforementioned Femmebots? I was fine with it until I read the "perfectly shaped" bit ... then my focus shifted.
Posted by mrpink , Nov 19, 2008 1:57PM
450x500 was a quote i recall someone saying. Chatter going around that at one pt today we hit 550? Can anyone confirm?
-mrp
Posted by guest , Nov 19, 2008 1:58PM
For a moment I thought that said "Short Terrorism Hits Berkshire"
Posted by guest , Nov 19, 2008 1:59PM
Maybe everyone is realizing the shittiness of a lot of the BRK businesses, absent the Warren halo.
Also re the probability of those puts expiring in the money, lets not forget that it took until 1954 for the Dow to climb back above the 1929 highs. Which is longer than the time to expiry of these things.
Posted by guest , Nov 19, 2008 2:06PM
S&P 500 at today's level in 11 years? That's not unfathomable. We've been in a secular bear market for 8 years now. The last bear market lasted 20 years...
Posted by guest , Nov 19, 2008 2:07PM
HAHA, Fuck Warren Buffet. For some reason America thinks he's some kind of benevolent investor grandpa when he's really a self serving filthy bastard.
Don't get me wrong, greed is good. But trying to pass yourself off as an altruistic know it all is bullshit. I'm glad the hypocrite is eating it on credit default swaps.
He makes himself out to be a harmless old codger, but inside... inside...
Posted by guest , Nov 19, 2008 2:08PM
So who was the counterparty? Pension funds?
Posted by guest , Nov 19, 2008 2:11PM
"penned at then-market strikes with 15-20 year expiration dates...", not "penned at then at-market strike..."
(nor "penned then at-market strikes", which is what you were trying to do)
what kind of limey are you?
Posted by guest , Nov 19, 2008 2:12PM
There has been too much violence, too much pain. None here are without sin.
But I have an honorable compromise.
Just walk away.
Give me the pump the oil the gasoline and the whole compound, and I'll spare your lives.
Just walk away. I will give you safe passage in the Wasteland.
Just walk away and there will be an end to the horror.
EP you're awesome.
Posted by guest , Nov 19, 2008 2:13PM
i.love.perfectly.shaped.breasts
Posted by guest , Nov 19, 2008 2:16PM
Right - as was pointed out in commentary yesterday, if this is really the motivation, people are buying 5-year credit protection for a contingent liability that hits 14-19 years from now. Term mismatch much?
Not to mention that $4.5B of premium invested for 14 years is going to soak up a huge chunk of any payout.
Who paid $4.5B for these things??
Posted by guest , Nov 19, 2008 2:17PM
900+ words too long
Posted by guest , Nov 19, 2008 2:18PM
Who's on the other side of these trades?
Posted by guest , Nov 19, 2008 2:27PM
Doesnt the accting treatment he mentions:
Changes in the value of a derivative contract, however, must be applied each quarter to earnings.
only refer to bona fide hedging transactions?
Posted by VOL IS KING , Nov 19, 2008 2:32PM
Maybe its the fact Buffet invested at twice the current market price for GS and 40% or so above for GE which has subsequently received back door bailouts from FDIC and the Fed, and it has come to light GS thought it had to merge with Shiti group in order to survive. The long term viability of both seemed certain at the time and now, not so much. Sure few people realized this but Buffet is supposed to be an Oracle after all. (aside, i could totally see a GE-Citi merger with GE becoming a Bank and Vik becoming CFO)
Either way it seems like the old coot may finally be losing it. Couple that with the fact that as you point he is mortal which means in 19 years Berkshire will just be another insurance company in all likely hood. (Assuming it still exists) Considering Buffet's current display of his mere mortality, CDS for Berkshire sans Buffet is just trading inline with other other large financial institutions that have CEOs who are not immune to the constraints of the space time continuum like the Oracle.
But I'm sure Ajit Jain has a delorian so Berkshire should be fine......
Posted by guest , Nov 19, 2008 2:35PM
"To put it in perspective, the S&P 500 would have to be trading at under 300-500 today for similar puts to expire in the money."
How the fuck did you come up with these numbers.
Posted by guest , Nov 19, 2008 2:53PM
Good post EP...can we get a bberg chart of Berk CDS spreads?
Anyone have spreads on Big 3 CDS? I hear they are hitting Icelandic levels!
Posted by VOL IS KING , Nov 19, 2008 2:54PM
P.S. 17 is right your analysis is flawed EP. you're assuming the s&p would stay here the whole time, it could trade up and back down several times over in that time and the puts could end up well in the money without the country necessarily being food fubar. Investors could simply lose their apatite for equities as they did from 1929-1945 or they could simply reduce their long bias if everyone were 30 or 40% short it could take a long time for the market trade significantly higher without end of the world being at hand.
Lastly the bloomberg piece assumes the credit ratings for Berkshire are accurate to begin with. As we know the agencies are oh so good at rating complex financial institutions and instruments, particularly when institution has a perceived reputation of being smartest guys in the room. Citadel has been writing a lot of at the money puts as well, hows that workin out for that group of midwestern geniuses. Chicago and Ohama are only short (put) distance apart after all.
P.P.S. "THE FUNDAMENTALS ARE SOUND"
By WARREN E. BUFFETT
Published: October 16, 2008
New York Times
http://www.nytimes.com/2008/10/17/opinion/17buffett.html
Posted by ep , Nov 19, 2008 2:58PM
"Posted by guest, Nov 19, 2008 2:18PM
Who's on the other side of these trades?"
No one is saying.
Posted by ep , Nov 19, 2008 3:00PM
"But I have an honorable compromise.
Just walk away."
See? Nothing escapes the Humongous!
Posted by ep , Nov 19, 2008 3:08PM
"P.S. 17 is right your analysis is flawed EP. you're assuming the s&p would stay here the whole time, it could trade up and back down several times over in that time and the puts could end up well in the money without the country necessarily being food fubar. Investors could simply lose their apatite for equities as they did from 1929-1945 or they could simply reduce their long bias if everyone were 30 or 40% short it could take a long time for the market trade significantly higher without end of the world being at hand."
If equities continue to be in such poor condition until the expiration of these puts, I find it very hard to believe any of Berkshire is going to survive well. If the return on the S&P 500 and whatever other two indexes the puts have as their underlying ends up literally below zero percent on expiration, I really don't think Berkshire is going to be that worried about the payout on those puts. Do you?
I don't think WB is the great genius that many credit him to be. But, this is a cat bond. He loves to sell cat bonds. And, he still gets to use the $4.5 billion for the duration.
Posted by guest , Nov 19, 2008 3:11PM
Related to #12 above: Yes, a term mismatch. But that's not really the point. The point of buying 5 year CDS contracts (assuming those are the most liquid) is that it flattens out the current unsecured exposure to the credit...It hedges what is known as "jump" risk. The amount of open exposure on credits are financial disclosure issues, to regulators, rating agencies, etc. Saying the exposure is hedged is much preferred by regulatos, rating agencies, and stock analysts than simply showing the gross number by ratings category (and generally speaking, it is not permitted to disclose specific counterparty names of these transactions).
Ever since the first ruminations of AIG downgrade related to their AAA CDO exposure (which had similar down-grade linked collateral language to what is surmised here) risk managers at all banks and dealers have sought to reduce all unsecured corporate exposure. With the major decline in the underlying indices, the unsecured exposure that these banks have on these equity puts to BRK (and other things that Berkshire does in other markets that also increase bank exposure to BRK), they need to go and buy more, thus driving up the price.
The aforementioned article is a good example of "B" reporting. The "C" job would have explained only that BRK spreads have widened and omigod that means that BRK is in trouble. The A-job would have talked about the tremendous irony of how Warren gets all this press about derivatives are "weapons of mass destruction" but uses them extremely creatively himself (or at least, Ajit does) across major markets as low-source cost of funds and investment tools, thus leveraging his credit rating and cost of funds in ways that could not be accomplished in the cash markets.
Contrary to the comment in #16--it's savvy as heck, a great example of taking what Wall Street is giving you, and actually shows that Warren and Ajit will use any tool they can to make money...I just wish Warren would drop the "aw shucks I just make money the old fashion way" routine and admit that yes, he's made a lot of money for his company by using these "Weapons of Mass Destruction."
Posted by guest , Nov 19, 2008 3:12PM
@17, she means that if similar puts were written 20-15 years ago (when the S&P was ~300 to ~500), the S&P would have to be in that range today for the puts to be worth anything. And even after the rather disconcerting drop in the S&P recently, such puts would still be way out of the money.
Btw, doesn't option theory say that American style options = the value of European options since it's always a bad idea to exercise before expiration (and thus extinguish option value)? If so, that ~$4 billion mtm liability might be a bit worse than we think. This might only apply to calls though.
Posted by guest , Nov 19, 2008 3:32PM
Only equal if there is no cash flow from the underlying.
Posted by VOL IS KING , Nov 19, 2008 3:35PM
Jesus fucking Christ EP.
If you wrote ATM S&P 500 puts in 2000 that expired this year you have a serious problem. Does that mean that we have been in a recession since 2000?
Maybe the index trades down another 50% this year and they return a steady plus or minus 15% for the next 18.
Maybe index trades up for for or six years but then has two down 30% years.
Maybe the index stays relatively flat and then there's a shit show in 15 years.
The S&P didn't advance at all in the 1971-1980 and yet the country is still here. What're you retail all of a sudden?
Posted by ep , Nov 19, 2008 3:36PM
@24
Ah yes, thank you. I wasn't sure what the commenter was critiquing originally. That seems to have been it.
Sorry, I should have been more clear in the post. My point was exactly that. If those options were written 15-20 years ago, the S&P would have to be at rather astoundingly low levels for them to pay off. Even the crushing dip we've seen so far still would have those options out of the money.
Since the term of the options is 15-20 years and the first come due 2019, that would suggest they were written 2004ish. I'm not sure if its the S&P 500 or the other indexes that have the 15 year term, but assuming it is the S&P 500, the strike "at market" would have been, what, between 1060 and 1215? Of course, WB has the fact that we saw an amazing spike in equities culminating in that period working against him.
Also, we are ignoring the possibility that these are amortised options, where the payout is linked to average underlying price over a period, Asian options, or some other exotic payoff calculation that is a little less crude than simply the closing S&P on a single date after 15-20 years.
We will see, I suppose.
Posted by guest , Nov 19, 2008 4:02PM
17 op here
I understand your point better now, it was a little unclear. Still take the Nasdaq or Nikkei from the past and neither index is near their peak. As always the devil is in the details. We don't know what the strike price actually is or how many options were written. It could be a billion shares for all we know so a one or two dollar decrease in the index could create a huge problem.
Posted by VOL IS KING , Nov 19, 2008 5:01PM
ep
Also this is no cat bond. Observances of hurricanes don't change the future probably of hurricanes. (maybe your estimation as you update your sample data, but they don't cause next years huricanes) that's why it makes sense to go in right after one and write insurance at a higher premium while people are scared out of their wits. But obviously observed returns of equities effect futures returns on equities.
1) in that if the market is down 50% obviously it has to double just get back to at the money.
2) more importantly it changes the behavior of market participants, falling prices reduce the demand for equities because people reasses their risk tolerance and that reduces future demand for shares. The further down they go and the longer they stay down the less demand there will be. Like you, investors expect equities to up, if they don't up people don't want to buy them anymore, if people don't want to buy them, they ain't goin up.
Buffet is not so niave though, he lived through the 70's this is a pure volatility trade. When the market calms down in a year or five. he'll siddle up to some 27 year old derivatives desk head who was getting wasted in college when this was going down and barely remembers any of these years. The 27 year old will be excited just to say he's doing trade with warren buffet, i'm sure buffett'll get a sweetheart deal, as always. Buffet will buy straddles for a much lower premium than the puts he wrote, at some point in the next 17 years when the market is up. he'll stop out his down side and double up his return if/when the market continues to goes up. The put won't have to be out of the money for him to make money cause he's gonna be buying calls at a lower price. hell make money on his calls and on the puts he wrote.
And that's how you play the game. Weapons of financial mass destruction, my ass. I take it back, the old coot is as sharp as ever. when demand for shares does come back he'll make a killing... and he'll probably unwind the trade then rather than waiting til expiration.
p.s. Reread alchemy of finance, geometric growth works in both directions, and so does "reflexivity".
Posted by VOL IS KING , Nov 19, 2008 6:02PM
oh snap, reality check.
i bet the cds has nothing to do with puts sale there's a shit load of high net worth individuals out there who own berkshire. but there are no options so everyone who's lost money on all their other stocks and are scared but want to hold on to berkshire they turn to their broker at Goldman or Morgan stanley or where ever and say please hedge some of this for me i don't want to be worth less than $40mn the shares are hard to borrow plus a bunch of hedge funds are shorting berkshire cause of GE, Goldman, AMX so the only way for people long BRK to hedge is to buy CDS that's why the cds spreads have blown out like that. The put sale is a fucking red haring.
yeah so there's a trade in there for you boys and girls short shares write brk cds or buy the bonds.
-Its good to be King
Posted by guest , Nov 19, 2008 9:49PM
VOL IS AN IDIOT
You're right there is no way to hedge other than CDS, jesus pick up a wealth management brochure from any company. Its simple, short the stock, buy the CDS, and apply pressure so they get downgraded and have to put up more capital. Continue cycle until all hell breaks loose.
Posted by guest , Nov 19, 2008 10:05PM
The average level of the S&P 500 between 2004 and 2006 was about 1150 (and it was between 1100-1200 for most of that period), now it is 800. So the market is down 31% since the options were written.
Using a standard Back-Scholes model, assuming a 17.5 year option (the average reported maturity), dividend yield of 1.5%, risk-free rate of 5%, and 20 year S&P volatility of 25% (the standard insurance companies were using for long volatility back then), the options struck at-the-money on a spot (not forward) basis AT THE TIME WRITTEN were worth $12.50 for every $100 of notional underlying value. Berkshire is reported to have been paid $4.6 bill for $37 bill potential loss or around $12.50 per $100. So the above assumptions are consistent with what they reported.
Today, using 15 years until maturity, dividend yield of 1.5%, risk-free rate of 4% (bond yields have come down making the options worth more by themselves), and 15 year volatility of 25% (Not increasing market volatility) and a spot price that is 31% in the money, the options are currently worth $25 for every $100 of notional underlying value. Or double what Berkshire was paid consistent with a $5 billion write-down.
However while there is not much of a liquid market for long-dated options the volatility someone would write them at today has to be higher than it was 2.5 years ago at the bottom of a mulit-year low in volatility. (e.g. at the bottom of the LTCM crisis implied volatility for long-dated index options hit 50% and realised volatility was a lot lower then than now).
So using a volatility assumption of say 37.5% increases the market value of the Berksire options to $36 per hundred. This implies a Berksire writedown on a fair value basis of around $10 billion.
So the mark-down they took of $7 bill is a bit light considering that to cover these babies, I bet they would have to pay closer to 50% implied vol just as IBs had to to cover positions they lost when LTCM went under. (At that level Berkshire should have taken a $15 bill hit on these options).
Actually the real idiocy of their strategy as originally stated was that they would invest the premium in the equity markets. The above values assume that they hold the premium (and any revaluation) in riskless bonds. If they invest in equity which is what they are insuring against it is like taking the proceeds from writing hurricane insurance for miami and buying houses in miami. When you need to pay, even the premium gets blown away.
Posted by guest , Nov 19, 2008 10:20PM
@31:
Don't fuck with me today you stupid piece of shit. You can't automatically short shares you fucking moron. First you have to find someone to lend them to you. As I stated above Berkshire is very hard to borrow because everyone wants a piece of the Oracle and there aren't that many share outstanding because the stock has never split thus its $81,000 price tag.
What shares there are available have been lent to hedgistan. Which leaves a lot wealthy individuals who own the stock out in the cold. They love telling people they own Berkshire (owned it since 1984 best decision I ever made Johnson, when you make your first million pick up a few shares of BRK) they'd sooner part with their country club membership if there was a liquid market (note to self start exchange for country club memberships) but meanwhile their net worth is through the floor.
So they ask their investment advisors for a hedge for a hedge and the only instrument available is CDS. The brokers don't give a fuck what it costs they're just going to pass the cost on to their clients and the clients relatively incentive to price as long they can maintain enough wealth to afford them the lifestyle to which they've become accustomed. So the CDS just keeps getting bid up. Rather than the skew being expressed in the puts due to a long bias in BRK stock it is instead being expressed in the CDS.
Why don't call your broker and tell him you want to short BRK tomorrow 31 see what he says, you might be able to short A share. I'm not sure you want to lever up 8 million times your net worth though, a strong breeze would wipe you out.
Posted by VOL IS KING , Nov 19, 2008 10:41PM
Opp forgot to log in.
@32: How did you read this "We have received premiums of $4.5 billion, and we recorded a liability at year end of $4.6 billion." I'm not sure how the accounting works on this shit, but it sounds like to me Mr. Buffet may have already hedged his downside actually and this is a bull put spread where $100mn is the maximum loss (in which case he keeps that much in the trunk of his town car).
He didn't say he wrote $4.5bn worth of puts he said that was the premium they received, seems like careful wording to me. Like he specifically avoided saying we wrote put options for a price of $4.5 billion.
Posted by guest , Nov 20, 2008 10:38AM
@34, I read it the same way as you. THey got premium in of $4.5 bill,(increased their assets by $4.5bill) and set up a liability of $4.6 bill so net net a hit of $100mill at the end of the first year. I doubt seriously he has hedged anything from his comments. The only mention of the size of the position other than the premium are comments to the effect that they could pay out up to $37bill which i have taken to mean they wrote the puts on $37bill of S&P exposure and got in 4.5bill of premium (struck at the money spot in 2004-2006) the math ties out. If he had hedged it he would not have take a further $7bill hit to date on this P.o.S. Must be why Berkshire is down anther 10% today.
Posted by guest , Nov 21, 2008 3:03AM
The people bashing Buffett are the same jealous bastards who bashed him in 2000, and who also probably think Bush/Cheney did a great job. In other words, bitter, delusional, frustrated Charlie Gasparino-types.