What's Wrong With Berkshire Hathaway?

Berkshire Hathaway (NYSE: BRK-A  ) shares fell 12% yesterday, and today marks the ninth consecutive day of price declines. Equity investors appear to be fixated on the spiraling cost to insure Berkshire's debt, which has more than tripled over the past two months. As a result, the mispricing of the company's default risk has created an opportunity for patient stock investors.

The cost of insuring Berkshire's debt is now equivalent to that of insuring General Electric's (NYSE: GE  ) debt and greater than that for Goldman Sachs (NYSE: GS  ) . That's pretty ironic, considering both companies went to Buffett, hat in hand, during the past two months, deeming that an investment in their companies from Berkshire would reassure the market concerning their own viability (Buffett ended up investing a total $8 billion in the companies.)

But first, let's ground ourselves in reality: Berkshire is a legitimate AAA-rated company. The credit-default-swap market's main concern appears to be a large Berkshire derivatives trade, in which Buffett sold puts on the S&P 500 and three foreign stock indexes, with a strike price equal to the price of the indexes at the time the trades were initiated.

And just to be clear, selling puts on an index with a strike price of X equates to betting that the index won't fall below X.

Disastrous bet ... or shrewd trade?
The trouble is, world stock indexes, including the S&P 500, have declined sharply since the trade was struck. The past two months have been particularly rough. In its third-quarter earnings release, dated Nov. 7, Berkshire said its loss to date on the trade is $1.87 billion. Surely, that's proof enough that Buffett made a disastrous bet. Right?

Wrong! In fact, Buffett had fully anticipated the possibility of such losses. Describing the trade for the first time in his 2007 letter to shareholders, he wrote: "... our derivative positions will sometimes cause large swings in reported earnings, even though Charlie [Munger] 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."

In truth, the terms of the trade are highly favorable to Berkshire:

  1. At inception: Berkshire, the option seller, received the full $4.85 billion in option premiums up front. The use of this cash is now entirely at Buffett's discretion. Given his track record as an investor, that's a very valuable feature.
  2. Over the life of the option: The puts are so-called "European" options -- the buyers can't exercise them until they expire. Furthermore, it's unlikely that Berkshire would have to post any margin collateral against mark-to-market losses; thus, although such losses would reduce Berkshire's earnings, they have no economic impact on the company whatsoever.
  3. At maturity: These are long-dated puts, with expiration dates falling between 2019 and 2027. This is an immensely favorable situation, in light of the first point and the long-term upward drift in the stock market.

Given the misunderstanding of this options trade in the credit-default-swap market, which sets the price of insuring a company's debt, I now think the greatest economic risk of this options trade is not inherent in the trade itself. Rather, it is that the credit-rating agencies, including Moody's (NYSE: MCO  ) and Standard & Poor's, will also misunderstand the risks of the trade and downgrade Berkshire, in a move that would increase its cost of funding.

Do you want more evidence that Berkshire's risk is misunderstood? The five-year credit-default-swap spread hit 440 basis points yesterday. That means the annual cost of insuring $10 million in Berkshire debt against default over five years is $440,000. The following table contains the same cost for other companies and sovereign issuers that have experienced substantial moves in their credit-default-swap spreads recently:

Corporate/ Sovereign Issuer

Standard & Poor's
Credit Rating

5-Year CDS Spread (On 11/18, in Basis Points)

Berkshire Hathaway

AAA

440**

Citigroup (NYSE: C  )

AA-

360

American Express (NYSE: AXP  )

A+

386

Deutsche Bank (NYSE: DB  )

AA-

119*

Markit CDX North America Investment-Grade Index (125 companies in the U.S. and Canada)

Companies in the index must be rated BBB or higher

229

Republic of Colombia

BB+ / BBB+ (foreign / local currency)

416**

* At Nov. 17, 2008.
** At Nov. 19, 2008.
Sources: Markit.com, media reports.

Remember that you should expect an inverse relationship between the credit rating and the cost of insuring debt -- the lower the risk of default, the higher the credit rating (AAA being the highest), whereas the greater the risk of default, the higher the cost to insure an issuer's debt.

With that in mind, a glance at this table is enough to suggest that Berkshire's default risk is obviously mispriced. It doesn't make sense that it should cost more to insure the debt of Berkshire Hathaway -- an extraordinary collection of extremely profitable businesses with an armor-plated balance sheet -- than that of lesser-quality businesses/insurers.

Ask yourself: "Would I rather lend money to Berkshire Hathaway or the Republic of Colombia?"

A golden opportunity to own one of the best companies in the world
Shareholders would be better off worrying about getting hit the next time they cross the street than fret about seeing Berkshire becoming a bad credit. Better yet, true value investors should seriously consider taking advantage of this fear spillover from the credit-default-swap market to add to their holdings. And if you don't already own Berkshire shares, this looks like a genuine opportunity to pick some up at discounted prices -- something that doesn't occur all that often.

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Alex Dumortier, CFAhas no beneficial interest in any of the companies mentioned in this article. Berkshire Hathaway, Moody's and American Express are Motley Fool Inside Value recommendations. Berkshire and Moody's are Motley Fool Stock Advisor selections. The Fool owns shares of American Express and Berkshire. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (97)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 20, 2008, at 5:28 PM, yidd wrote:

    It would be helpful to know what the indexes at issue are and the price at which a put is likely to be exercised. Is there a way of knowing?

  • Report this Comment On November 20, 2008, at 7:18 PM, SkepticalOx wrote:

    yidd,

    I'm not sure if that really matters right now. First of all, they are European style options, and they can't be exercised until 2019 at the earliest.

    I think there were estimates in the past that the put options were for the indexes to be 30% lower than they were at the time (though I'm not sure if this is true). That would probably put the puts in-the-money. But hey, it can't be exercised.

    Lastly, if the puts end up being in-the-money in 2019, Berkshire would be able to purchase those indexes at what would supposedly be discounted prices vs. when they were issued.

    Unless we get whacked by a really bad depression that lasts the next decade, or there's one then, I think Berkshire will win either ways.

    Hopefully those credit rating agencies don't screw it up.

  • Report this Comment On November 20, 2008, at 9:11 PM, jed2000 wrote:

    yidd,

    At

    http://seekingalpha.com/article/107153-berkshire-hathaway-cr...

    Whitney Tilson estimates that if all the stock indices went down all the way to $0 in 2019 and beyond, then Berkshire Hathaway would be exposed to $37 billion in total losses, minus the $4.85 billion paid for the puts, plus any money made from those puts. Of course it's unlikely in the extreme that all the indices will go to zero, and I think we would have other problems to worry about in that case. In a more likely scenario of a severe bear market where stock indices are down 17% from todays levels in 2019 and beyond, he estimates an exposure of about $18.5 billion minus the $4.85 billion and any money made on the $4.85 billion. Since Berkshire Hathaway can afford to buy the stock indices even in the worst-case scenario, it does seem that any concerns about Berkshire Hathaway defaulting are completely absurd.

  • Report this Comment On November 20, 2008, at 11:02 PM, sixman123 wrote:

    This article doesn't pass the laugh test. If Berkshire sold put options for $4.95bn and now those options are worth X, then the profit (or loss) is $4.95bn - X. Just because we're talking about options and not any other asset doesn't change that reality. The value of the options right now is determined by what other people are willing to pay for them. We can model the value using the Black-Scholes formula -- the most important inputs to which are current stock prices, interest rates, and implied equity volatility for the next 10 years. Of these, implied volatility is by far the most significant factor and it has risen dramatically in the past 2 months to the point where the options market projects the next decade to be as volatile as the 1930s were. Needless to say, the professionals who trade Berkshire's credit and equity have figured out that X must be much larger than $4.95bn. Given that no institution except maybe the US government could afford to sell these options back to Berkshire right now (because of the size of the risk involved), it's not clear if anyone really knows what X is.

    If you agree with the author of the article that these options won't blow up Berkshire between now and 2019 (just like AIG was blown up to the tune of $120bn by put options it sold on CDOs and mortgages), then you should buy Berkshire stock or bonds (or sell credit protection). I have no clue where equities will be 10 years from now but my guess is that Buffett's trade probably works out for the same reasons that were mentioned in the article. But to say that the prices in the credit default swap market imply a "misunderstanding" of the options is ridiculous and naive. Berkshire has lost a lot of money on this trade (it very well may make it back in the future) and the market is reflecting that reality.

  • Report this Comment On November 21, 2008, at 7:35 AM, MLindeboom wrote:
  • Report this Comment On November 21, 2008, at 9:41 AM, TMFAleph1 wrote:

    sixman123,

    Berkshire Hathaway's situation really isn't comparable to that of AIG. The value of the put options Berkshire has sold can't exceed the notional value of the indexes on which they were written -- $37 billion. That may look like a lot of money on the face of it, but even that catastrophe scenario wouldn't bankrupt a Berkshire Hathaway in 2019. AIG's CDS exposure exceeded reached $440 billion dollars.

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On November 21, 2008, at 1:19 PM, Dadw5boys wrote:

    Ok !!!!!!!!!

    This is pure market Manipulation !!!!!!!!!!

    BARCLAYS IS THE MAJOR HOLDER IN ALL THE BANKS THAT GOT TRAP FUNDS !!!!!!!!!!

    SOMEONE IS PLAYING THIS SO THAT MAJORITY OF TRAP FUNDS GO TO BARCLAYS !!!!!!!!!!!!!!!!!!

  • Report this Comment On November 22, 2008, at 10:20 PM, Sridhartoronto wrote:

    Selling long term PUTs is a very conservative strategy which doesn't pay much. It doesn't have too much risk either. Buffet can't be losing too much on this trade. The volatility now is ridiculously high and that's creating a paper loss.

    But then it exposes a few chinks in Buffet's infallibility. Was he REALLY thinking that the S&P 500 couldn't fall much further when he sold those PUTs? Did he REALLY believe the valuation?

    I think he is growing senile. His investment in GS made no financial sense then and now.

    The reinsurance business also has me worried. What kind of assets did that hold? Maybe that's what is being reflected in the stock price today.

  • Report this Comment On November 23, 2008, at 1:24 AM, TMFAleph1 wrote:

    Sridhartoronto,

    Thanks for your comment.

    Buffett isn't growing senile yet -- he can still give investing lessons to those who are willing to observe him. Even though many media observers are unwilling or unable to present it accurately, his investment in Goldman makes plenty of sense -- check out the following article for a fair-minded explanation:

    http://www.fool.com/investing/value/2008/11/14/did-buffett-m...

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On November 23, 2008, at 2:23 PM, HappyEndingz wrote:

    Thanks Alex,

    You make a great case that Mr. Market has (once again) mispriced a risk.

    But one factor here needs further attention. Mr. Buffett received $4.85Billion (!) in option premiums which he is free to invest now, today, in his favorite playground (hint: it growls) until 2019-2027. Given his outstanding success at putting money to work in the 1962, 1968-69, 1973-74, and 1987 market downturns, the potential compounded gain here is no small matter.

    In the end, even if he does lose the initial bet , however unlikely, he still keeps the compounded gain which I will hazard to guess will more than exceed the $37Billion due at expiration. Of course, if he wins the bet, he keeps the float and gain. Sweeeet... with Cartman-like intonation.

  • Report this Comment On November 28, 2008, at 10:59 AM, BaloneyII wrote:

    Well, having bought Berk B shares since Inception and 1 share per yr vs my into my IRA?

    Has done a pretty good job.. v s Bonds..

    Everytime It drops like this? I accelerate my Annual Buy and Buy it ..which is now.. vs waiting for my 2009 $ for it..

    It's just a Gamble..no matter what you invest in..

    Look at the Corp. bonds, many Muni's going bankrupt and not to say about Equities..

    which will have to go up over 80% to just get back to even again.. To do that? I'be buying Some 2-1 Margin BULL funds.. or invest more into your best Equity Funds that did the best in the alst Recovery of 03'...

    And just hope for the best..

  • Report this Comment On November 28, 2008, at 12:26 PM, threepennybit wrote:

    AHA! So, respectfully speaking, this Buffett fellow is part and parcel of these obscure derivatives that have brought us all to our financial knees after all.

    So he is not Father Christmas after all - what a surprise! Just another clever Midas who made himself staggeringly rich at others expense and then preaches about what others shouldn't do.

  • Report this Comment On November 28, 2008, at 2:24 PM, tiafolla wrote:

    threepennybit said: " this Buffett fellow is part and parcel of these obscure derivatives that have brought us all to our financial knees after all."

    Not at all. While a put is technically a derivative, it's a very simple, well-defined one. Selling puts is a standard, common investment strategy with known risk limits and with immediate business benefits (remember he gets almost $5 billion to play with for 10 or 15 years).

    It is nothing at all like the overleveraged, unknown/unlimited risk moves that built the house of cards that is now collapsing. If everyone had acted as conservatively as Buffett, the markets would be in excellent shape. There's just no comparison.

  • Report this Comment On November 28, 2008, at 3:46 PM, lstephen1 wrote:

    Your headline is very misleading. What happeded to B-W is what happeded to almost all other stocks!!!. Do you think B-H is immune to market swings??. The stocks B-H owns are the same stocks the common investor owns, only larger amounts!!!!!!. Stop looking to use sensational headlines and learn some professional journalism!!!!!!!!!!!!!!!!!!!!!.lstephen1

  • Report this Comment On November 30, 2008, at 10:44 AM, threepennybit wrote:

    tiafolla: WB says thanks for supporting him! However, Threepennybit, who appreciates your post, says that nice Uncle Buffy might not be as marvellous as is the perception about him. No one personally makes the quite astounding figure Uncle Buffy has made on nice polite little options like Fools get to play with. No one. And what is really odd is that no one seems to think that the how's, which's, why's and wherefor's of these humungous billions should be questioned.

  • Report this Comment On November 30, 2008, at 12:48 PM, MrMighty wrote:

    Well, threepennybit, I don't think he needs to be sainted or anything - he's simply a rational investor. As for getting special deals that allow him to make billions, he is afforded that opportunity because he has shown himself to be patient capital with deep pockets who won't be putting his company out of business on unwise bets. If you were a huge pension fund looking to insure against the downside, who would you rather go to these days - Berkshire Hathaway, or one of the big Wall St. players whose very survival is questionable from day-to- day?

    When you've proven yourself over the same term, and have billions in assets and billions in earnings each year, you may find that you too can get the same opportunities.

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