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Commentary

Buffett Crosses Over To The Other Side

I often hear people quoting Warren Buffett saying “Derivatives are weapons of mass destruction”, and thus, that derivatives are ultra-horrible, a bad thing, a sin, and what not.

What Buffett says is not what Buffett always does. Berkshire Hathaway, the company he runs, had it’s net income falls64 percent because of derivatives.

Berkshire Hathaway Inc. said Friday its first-quarter profit fell 64 percent because it recorded an unrealized $1.6 billion pretax loss on its derivative contracts, and its insurance businesses generated lower profits.

Berkshire reported net income of $940 million, or $607 per share, in the quarter ended March 31. That’s down significantly from the net income of $2.6 billion Berkshire generated a year ago.

Berkshire’s chairman and CEO Warren Buffett warned shareholders in his annual letter that the derivatives could make the company’s earnings volatile. But he predicted the derivatives will ultimately be profitable.

Including the derivative losses, Berkshire’s net investment losses in the quarter totaled $991 million. A year ago, the Omaha-based company recorded a $382 million investment gain.

Berkshire’s derivatives fit into two major categories. Berkshire will have to pay on some of the contracts if certain U.S. entities default on their credit. Most of the other derivatives will only be paid if the certain stock indices are lower in 15 or 20 years than they were when the contract was written.

Berkshire has received $2.9 billion in premiums on the credit-default derivatives and $4.9 billion on the stock index derivatives.

Berkshire said its operating earnings are a better measure of how the company is performing in any given period because those figures exclude derivatives and investment gains or losses. Berkshire reported $1.93 billion in operating earnings during the first quarter, which was down from $2.21 billion in operating earnings a year earlier.

Berkshire’s insurance group, which includes Geico, reinsurance giant General Re and several other firms, contributed $181 million to net income from underwriting new policies. A year ago, Berkshire’s insurance companies generated a $601 million underwriting profit.

Buffett has said he expects insurance profits to fall during 2008 because increased competition has driven premium prices down, and a catastrophic loss could further hurt insurance profits.

Emphasis mine.

Now I don’t think you should hold Buffett to his word. This is a business where being fickle is a good thing. When circumstances change, you change. Buffett probably meant his mass destruction statement when derivatives were being sold with no idea about risk. But today when risk is priced in, derivatives are much more attractive for a value investor.

Berkshire’s business itself is partly insurance. Insurance, I believe, is like a derivative, and that is in effect what Buffett has done – insurance on certain credit not defaulting, and insurance on the index not falling over twenty years.

Not that it is a good idea because I have no idea what twenty years will do and would never write the insurance. You can only come out in two ways – looking like a hero, or totally bankrupt. There’s no “in-between”. And the number of events, or “black swans” that can happen are ridiculously high – high enough to bankrupt you.

Take the put option Buffett has written on stock indices. Assume a 50% fall from here. He has received about $4.9 billion in premiums. For example a Dow Jones Index put at 12,000, over 20 years, he might get around $1165 per unit, and since they’ve said around $4.6 billion total premium received, means around 4 million shares which translates to a strike value of $48 billion. Margin requirements for such options are typically $2.5 billion (at 5% margin). That means for an equivalent put option, the margin required is $2.5 billion, for an exposure of $48 billion. If the index falls 50% anytime in the next 20 years, there will be a mark to market loss of $24 billion (though the option cannot be exercised until 20 years later). This $24 billion will be required as a maintenance margin, cash that the company can’t technically use. Right now the company has around $36 billion, but if the stock markets hit lows, the cash may be required to purchase or bail out companies – the way Buffett has traditionally grown. Not having that avenue is horrendous – and this is just one index option written – there are other things that require margins (insurance, CDS etc.)

It may sound like a 50% loss is not quite forthcoming or in the horizon, but who can ever see these things? I would want to be on the buy side of that equation, using short term puts as a hedge instead. Far more predictable, and controllable and loss protected.

And that’s just the index puts. There are credit derivatives, which assume no credit defaults by the underlying companies. What if that doesn’t pan out?

Coming to the rest of the highlighted items. Note carefully – operating income has gone down. Insurance business has gone down in 2007, and is expected to be worse in 2008. Businesses like Amex, Wells Fargo et. al. are due for a subprime hit, and the residential problems will hit the furniture/carpeting businesses. Life isn’t going to be easy the next few years.

In a lot of ways, this is huge change in outlook for one of the world’s most admired investors. We must wait and see how well he reacts. One lesson though: Do not believe what Buffett says is what Buffett will always do. Because in this business, people change – and for good reason.

  • Rajiv says:

    >Buffet is known for his honesy, principles and ethics.. lets see what explanations he will offer in the Saturday meeting.

  • Hari Swaminathan says:

    >Your interpretation of Buffett’s “Weapons of Mass Destruction” position is not accurate. When used by “masses” who don’t either understand what they are or what they are meant for (read: speculative purposes or easy money as opposed to hedging their portfolios), they become WMDs. This is exactly what Buffett preaches. He has never said that institutions, corporate finance departments or other knowledgeable people should not use derivatives. Given the host of problems these professional organizations are themselves facing worldwide because of derivative misuse, his words could not ring more true. Berkshire certainly comes under this category of professional asset management. If Buffett can live in the same house for 55 years, and drive the same car for over a decade, I think its crazy to suggest he’s “moving over to the other side”.
    Hari

  • Rohit Chauhan says:

    >Deepak

    warning – long comment here .. 🙂

    The put option buffett has written is similar to supercat insurance written by them. the company gets a premium and insures a low probability event. if the event occurs then the company has to pay the insured amount. now over the years buffett has indicated the they could lose money on specific policies, but over a long term , they work with odds on their side and would make a profit.

    in case of the put, although we do not have the specific details, i would assume a similar approach. in addition buffett has indicated that he looks at the exposure also (total max loss) and no matter what the odds would never risk a huge amount. the puts are deep puts and the odds of the markets being lower 20 years later is low (we dont know what is the strike price of the puts, but they are based on the index and not on a company).

    i think there are no margin requirements here because these are options written by berkshire with a counterparty. i dont think there is an exchange involved here. the counterparty is betting that berkshire would payup 20 years later if the options are below strike price. berkshire only accounts for MTM losses which are accounting or book keeping losses if the options are closed today (unlikely to happen)

    as far as insurance is concerned, berkshire is know for its discpline and has always written less policy if the market is soft ..which it has been due to absence of any major catatrophes

    the other companies which are owned by berkshire wholly or via stock have strong competitive advantages, so they will do well than average over a complete business cycle.

    i think for berkshire quarterly results are not important (unlike other companies)..their performance is volatile due insurance and because buffett doesnt try to smooth earnings in the short term. he prefers to take decisions which may lose money in short term but do well in long term

    ofcourse media is going to make a show about this drop as they dont understand the company

    regards
    rohit

  • Deepak Shenoy says:

    >hari: I disagree. Read the relevant bits from Buffett’s 2002 annual report.

    “I view derivatives as time bombs, both for the parties that deal in them and the economic system.
    Basically these instruments call for money to change hands at some future date, with the amount to be
    determined by one or more reference items, such as interest rates, stock prices, or currency values.”

    “The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in
    variety and number until some event makes their toxicity clear. Central banks and governments have so
    far found no effective way to control, or even monitor, the risks posed by these contracts. In my view,
    derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are
    potentially lethal.”

    Read the entire thing – he castigates derivatives, regardless of the hands they are in. It is this attitude that has turned 180 degrees it seems, as the risks involved seem to be understated. Note again that the contracts Buffett takes are speculatory and not hedges.

    Just because he had the same house and car does not mean he has the same views too. People change all the time in this business, and there’s nothing wrong with that.

  • Deepak Shenoy says:

    >rohit: Here’s the 2007 annual report.

    The puts are between 15 and 20 years, written at the market, for a strike price at the market at that time. (“These puts had original terms of either 15 or 20 years and were
    struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of
    $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between
    2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a
    level below that existing on the day that the put was written.”

    That’s four indices, and strike price at the rate sometime last year. (I hope the Chinese Index wasn’t involved! 🙂 Just kidding, it isn’t because he would have said so otherwise)

    Now the point is this – it’s not a covered put, and its not a hedge. The puts may be 15-20 years away but the risk to me is ridiculously high, as the leverage should be between 10x and 20x of the premium received, as the margin (recorded as the liability) is about equal to the premium.

    I don’t know about the counterparty thing – do you have a link? Everything in that annual report suggests this was an exchange traded deal. Or at least there must be someone who’s in between – who on earth takes that kind of a counterparty risk otherwise?

    Here’s the thing: I’m glad we are told about this. No one else ever talks about details, and this at least gives us a clue about the risks being taken. You see my problem is that no one can say they understand the risk, not even Buffett. Anything can happen in this meantime, and the risk of loss, from last year’s levels at least, can be enormous. Yes, they can hold to expiry, and at expiry the contracts can indeed by out of the money – but it’s not hedged, and requires good quantities of luck.

    Insurance and other earnings wise: I don’t mean that Buffett’s companies can’t come out of this alive, but they will have a very tough phase. Sacrificing short term for the longer term is all good, so we just have to wait and see. Insurance earnings slowdown is largely on the reinsurance end (BH Re) so you may be right, they may not be taking up quite as much there, but they’re doing the same on Auto, General Re and others.

    I think BH is a good company, and this is one of the biggest challenges Buffett will have to take since the bursting of the 1973-74 bubble. Let’s see how it goes.

  • Rohit Chauhan says:

    >Hi deepak

    we should not look at the put written by buffett as it is for the other companies – let me explain

    In the 80s buffett was buying cocacola and wrote puts on cocacola. he anyway would have bought the stock if the price dropped. however he wrote puts and would have used the puts to buy the stock and reduce his cost basis

    lets look at puts he has written and the math. they could lose money , but it is not as risky as it seems.

    he has premium of 4.5 billion. buffet can easily invest this at 10% per annum . so your are talking of this premium compounding to 18-22 billion by that time (5-6 times).

    these puts are written at current market levels. s&p is one of the index which quotes at around 14-15 times earnings. even with a 3-4% earnings growth if the market sells at the same level , it would be selling at 7-8 times earnings which would ultra cheap them. any lower than this would mean a depression at that time. so odds of that happening is low. in addition the losses that happens can be covered by the 18-22 bn which the premium has compounded to.

    also buffetts successor could look at actually using the put to accquire the index at the low valuation anyway.

    so this is what seems to be the idea – if the market does not crash, then the premium is in the pocket. if the markets do crash and sell at these very low valuations , the berkshire (not buffett maybe) could be looking at investing in the stock market and this put could be used to buy the indexes.

    as far as insurance i dont think there is any issue at all. gieco is doing well, and re-insurance market is soft and buffett has dropped volumes in the past several times in such market. so nothing new here.

    regards
    rohit

  • Deepak Shenoy says:

    >rohit: It doesn’t matter that you write puts to want to buy, because this is an equivalent buy of $40 billion plus! Buying the index at such levels locks your price to today’s levels minus 10% – not quite a value buy. I repeat – today’s levels minus 10% (the premium on the puts as I see it) is not value worthy.

    4.5 billion can’t be invested at 10% because that’s largely going to be needed as margin! So I doubt there are any returns (unless the indexes go UP) In fact even if it was, it would yield like 2.5% as the margin money. Plus, there may be additional money required as indices go down (remember these were last years levels)

    Now why would indices go down? Because earnings are not sustainable. S&P earnings growth may be negative if the recession is deep, and may not even grow at 1%. A P/E contraction would take the index to half easily, as in 1932(the S&P 500 didn’t exist then, but the dow did). In fact in 1932, the index lost some 90% from the highs. ALthough the P/E was high before, it’s wasn’t so low after because earnings had contracted.

    I don’t want to predict that this will happen. I just think this is a black swan waiting to happen, and if it does, Buffett is on the side of the very people he said were destroyed by derivatives. This transaction won’t destroy BH, it may cripple it severely.

    geico *was* doing well.Let’s see how it does after gas reaches $4 a barrel, and the economy recesses. Reinsurance may be soft, but GenRe is doing the same amount of business.