Wednesday, November 19, 2008

Buffet's Weapon of Self-Destruction

Almost everyone remembers famed investor Warren Buffet's remark that derivatives were "financial weapons of mass destruction."  Fewer people remember that Mr. Buffet's Berkshire Hathaway has made probably the biggest equity derivative's bets in history.  They are mentioned in its annual report here (page 47):

Berkshire is also subject to equity price risk with respect to certain long duration equity index option contracts. Berkshire's maximum exposure with respect to such contracts was approximately $35 billion and $21 billion at December 31, 2007 and 2006, respectively. These contracts generally expire 15 to 20 years from inception and they may not be settled before their respective expiration dates. The contracts have been written on four major equity indexes including three that are based on foreign markets. While Berkshire's ultimate potential loss with respect to these contracts is directly correlated to the movement of the underlying stock index between contract inception date and expiration, the change in fair value from current changes in the indexes do not produce a proportional change in the estimated fair value of the contracts. Other factors (such as interest rates, expected dividend rates and the remaining duration of the contract as well as general market assumptions) affect the estimates of fair value reflected in the financial statements. The carrying amount of these liabilities was $4.6 billion at December 31, 2007 and $2.4 billion at December 31, 2006. If the underlying indexes declined 30% immediately, and absent changes in other factors required to estimate fair value, Berkshire estimates that it could incur a non-cash pre-tax loss of approximately $2.3 billion."

I believe the options are, or at least mostly are, "plain vanilla" puts (on the Nikkei, SP500, Eurostoxx50, and the FTSE), meaning they have a strike price K, and Berkshire has to pay Q * (K - S) should the index finish at S (and below K) on the maturity day, where Q is the quantity of the contracts. Since S cannot go lower than 0, this would imply that the sum of Q * K, for all the contracts, equals 35 billion as of Dec 31, 2007. That's a huge number, by any standard. Notice that the total exposure has almost doubled from the end of 2006 to the end of 2007. Unless I'm missing something, that's an awful lot of new contracts in the year 2007.

It should come as no surprise that credit protection costs on Bershire have tripled in a couple of months. The collapse of equity markets has made these puts much more valuable, and if you're a holder of some of these puts, the only thing between you and relief is Berkshire Hathaway going belly up. So you do what you can - and buy protection.

Now I know, folksy Warren is considered to be a great investor. But, given any trend, there will always be one philosophy which fits the trend. Such is Buffet's "Buy and hold;" it works really well when you are living through the greatest bull market the world has ever known, which is pretty much what we've seen since the end of World War II. It doesn't work so well in a depression environment. So is Buffet a genius? Or has he just believed in the right philosophy at the right time? Or at least the right time through 2007, because times seem to have changed.

Nor should the similarity with AIG be overlooked. Sure, plain-vanilla puts don't suffer from some of the problems of the products which caused AIG to hit the wall, but the enormity of the nominal of Berkshire's bet makes the same result a possibility. Berkshire will need to keep lots of cash on hand in case it needs to make some big pay-outs. Its cash mountain is looking less a luxury and more of a necessity. 

Financial weapons of mass self-destruction, indeed.


ps said...

What did BH receive for these contracts? And how does that compare to the PV of paying out $35MM in 15-20 years?

Views By a said...

I think the premiums were in the 5 - 6 MM Usd range. (According to correspondence with the SEC, total premiums for the puts sold in 2007 were 2.9 MM Usd.) If you assume 4% interest compounded, that works out to about 8-9 MM Usd in 15 years.