You know, it's time to leave Buffett alone. It seems like everywhere you look, someone's criticizing the guy. Much of the criticism relates to the puts Buffett wrote against four major stock indices, betting that in 15-20 years, stock markets will go up.
People have accused Buffett of hypocrisy for using derivatives, which he has called "financial weapons of mass destruction." What's more, they think it's a bad bet, and have even suggested that Buffett is getting margin calls.
To top it all off, there's Fitch, downgrading Berkshire Hathaway's (NYSE:BRK-A) (NYSE:BRK-B) credit rating to AA+, largely because "Fitch views the company's potential earnings and capital volatility derived from its large, unhedged market exposures as inconsistent with the stability required at the 'AAA' level."
In their defense, at least Fitch is trying to do their job, which is more than they did for most of this decade when rating securitizations.
And they call me a Fool
You know what? Berkshire's had unhedged equity exposures for decades and derivatives exposure for years. Did it take 40 years for Fitch to figure out that the stock market sometimes goes down? Despite recent volatility, since 1965, Berkshire has compounded book value by 20% annually, with only two years in which book value declined. It still has $24 billion in cash. This isn't a weak company.
Regardless of what happens, Berkshire will pocket $4.9 billion in upfront premiums and anything he makes from investing those premiums. But, if the market falls, Berkshire has to pay an amount proportional to the percentage decline. If every index falls to zero -- almost an impossibility -- Berkshire will owe $37.1 billion.
And that $37.1 billion figure is what Buffett's most excitable critics point to.
The thing is, Buffett isn't stupid. He's a very thoughtful guy -- as far as I can see, far more thoughtful than most of the critics. Maybe they're harassing Buffett simply to get press, but if so, they should reconsider. Those who are inadequately equipped shouldn't become flashers.
The $700 trillion problem
Buffett isn't a hypocrite for using derivatives because he understands them. Derivatives are financial weapons of mass destruction only when they accumulate counterparty risk.
Suppose I buy $100 worth of Eli Lilly (NYSE:LLY) shares, betting that sales of Prozac will spike. But, I'm not comfortable with the downside, so I make a deal with you. If Lilly falls more than 5%, you'll make up any loss I have after the initial $5. My loss is now limited.
Now what happens if Lilly drops, but you go bankrupt and cannot make good on our deal? Suddenly, my Lilly is unhedged. I have to take an unexpected loss, which could cause me to be wiped out.
This is the mass destruction Buffett was talking about -- if one of the big, highly-leveraged players in the $700 trillion derivatives market fails, it can cause cascading defaults.
Risk avoidance 101
Despite this issue, Buffett can avoid problems because he understands the risks. He's the one who holds the $4.9 billion in premiums. If his counterparty goes belly up, Berkshire still has the cash.
What's more, Buffett knows that companies can fail because of a liquidity crunch resulting from the corporate equivalent of a margin call -- when businesses have to post collateral after a position moves against them or credit agencies issue a downgrade.
So, Buffett structures nearly all of these deals so that Berkshire doesn't have to post collateral in these situations. That's why the suggestion that Buffett was getting margin calls is silly.
A winning bet
What's more, these derivative bets are likely to be highly profitable over the long term. Buffett entered these positions from 2004 to 2008. Suppose that he suffers a loss equivalent to what would have happened if he made these transactions at the worst time in history, before the Great Depression.
If you compare the index from 1926 to 1929 to its price 15 to 20 years later, it was down some 28% on average. So, Buffett would have to pay $10.5 billion, or $5.6 billion net of upfront premiums he received.
But, Buffett is investing the $4.9 billion of premiums. Suppose today he put it all in Treasuries. From 2004 to 2008, the average yield of hypothetical 17.5 year Treasuries would have been approximately 4.75%. So, that $4.9 billion would grow into $11.1 billion -- Buffett would make a $600 million profit.
But Buffett can beat Treasuries. Over the last decade -- a period when stocks fell from a near-bubble high to the current lows -- Berkshire has compounded its book value by 6.44%. If Buffett can match that performance, the $4.9 billion would grow to $14.61 billion, for a $4.2 billion profit to Berkshire.
If Buffett can make 10%, the $4.9 billion would become $25.98 billion. 10% isn't unachievable -- Berkshire has recently purchased investments yielding 10% from Goldman Sachs (NYSE:GS), General Electric (NYSE:GE), and USG (NYSE:USG), and bonds yielding 15% from Harley Davidson (NYSE:HOG).
So even if this crisis is worse than the Great Depression, Buffett must wildly under-perform both his historical returns and risk-free Treasuries in order to lose money on these derivatives. Either one of those scenarios appears extremely unlikely.
The Foolish bottom line
Sure, Buffett's timing was poor, but it was a great opportunity that probably isn't available now. If today someone offers you a deal that will make you billions, it's a bad strategy to hold out, hoping that they'll come back tomorrow with a deal that will make you trillions. Buffett took what he could get, when he could get it.
Our Inside Value team still thinks Berkshire is extremely safe and offers good returns. Like Buffett, we think stocks are cheap, and that savvy investors will become to become wealthy as a result of this market. You can read about our top picks with a free trial to Inside Value.
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Fool contributor Richard Gibbons isn't actually the chairman of the Committee for the Beatification of Buffett. Richard owns shares of Harley. Berkshire and USG are Inside Value picks. Berkshire is also a Stock Advisor selection and a Fool holding. The Fool's disclosure policy only speaks Maltese.
