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Berkshire Hathaway
Hedging a Currency Disaster

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By rclosch
December 2, 2004

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Buffett's recent move into Foreign Exchange is remarkable for many reasons, first because of its size, which, at last report, amounted to $20 some billion in notational value. To say that this is a large bet is obviously an understatement. More remarkable still is the fact that this is the latest in a series of large macro bets. S&P puts, junk bonds purchases, and fixed income sales, actions so wonderfully out of character for the for the worlds greatest value investor, as to suggest that by some mysterious process Kiewit Plaza had been magically transported to Lower Manhattan and George Soros has taken position of the Oracle's body. .

Almost as remarkable as the nature of these transactions is the size of the profits they have generated. While It is way too early to judge the outcome of the FOREX positions, they have the potential to dwarf his earlier adventures. Buffett himself has characterized the transactions as a hedge for Berkshires wholly owned businesses against the decline of the dollar. But for Its shareholders, Berkshire itself has become a hedge against the sort of disaster that could result from the sudden collapse of the dollar. By this I mean that if the dollar where to suffer a sudden catastrophic decline the result might well be a sharp increase in interest rates and subsequent decline in the stock market. Berkshire's intrinsic value would increase not just because of huge profits in its FOREX positions but if the market decline is prolonged and sharp enough Berkshire would find its huge cash pile much more valuable, because of the opportunity to swallow large elephants whole.

So far the decline of dollar while accelerating since the beginning of the forth quarter has been orderly, but there is no guaranty that it will stay that way. A Wall Street Journal story last week placed the blame for the dollars decline at the feet of the individual foreign investors who have lost faith in the dollar, and are converting their dollar positions into local currencies.

It is important to understand that the Dollar has been in a steady decline for three years and is currently trading more that 30% below were is was in 2001. One measure of the extent the over valuation of the dollar is fact the even after a 30% decline in the dollar the U. S. trade deficit is still growing.

The main casualty of this decline so far, is our equity markets. It appears that some of the foreign capital sucked in here by the "Great Tech Bubble" Has already left the building.

So far foreign central banks have been absorbing dollars by buying US Treasury securities. Evidence of this is the fact that domestic long rates have remained stable as the dollar has fallen, this is so because of huge purchases of long bonds by these central banks. The three-year decline has left these Foreign Central Banks with a huge net loss on US Bonds they have purchased, yet their purchases have accelerated as the dollar has declined. This does not seem to me to be a stable situation, maybe these Central banks will continue to buy our bonds forever, but if they ever decide to cut their losses and dump their American bonds, the result could be quick and dirty, a further sharp drop in the value of the dollar and a sudden perhaps spectacular rise in our long term interest rates. Interest rates are basically the price of money, and if our bonds loose their biggest buyers we are going to have to pay a lot more refinance our debt.

Most international holders of U.S. Debt are currently suffering a negative return (the dollar decline is larger that the interest they receive) for the privilege of letting us use their money, and one wonders how long they will tolerate this. Granted the foreign central banks have a different agenda that the individual investor, but the longer they continue to buy and hold US Treasuries the more out of balance the dollar becomes.

Our Current Accounts deficit says that the dollar is still way overvalued. I have no idea how or when this imbalance will correct, but logic would indicate that sooner or later it will. "If something can not go on forever it will stop", and the longer these central banks support dollar (and the bond market) the more likely it is that the eventual correction will be painful. Buffett has very skillfully placed Berkshire in a position to benefit from any financial crisis that erupts. In view of this I think that any investor with positions in US equities should consider hedging the risks now inherent in domestic equity prices with a sizable position in Berkshire Hathaway.

Disclosure: the above is only my personal opinion. I have sizable positions in BRK in all my personal and client accounts. I do not claim to be impartial or completely objective and what I write should be read with that understanding. Nor do I claim that my crystal ball is any better that anyone else's.

rc


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