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:

* 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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