財經觀察 1540 --- Derivatives and the wisdom of the Sage

Poor dear Warren Buffett should have taken his own advice on derivatives, and stayed far away from those so-called financial weapons of mass destruction - because they just may be blowing up in his face.

Or at least, that’s what the CDS market is betting. On Tuesday, the cost of a five-year CDS contract on Berkshire Hathaway - a triple-A rated company, for what it’s worth - reached 415 basis points. Just two months ago, CDS on Berkshire traded at 140bp.

The reason for this swift deterioration in sentiment? The market appears to be reacting (belatedly or peremptorily) to the insurer’s exposure to a series of derivative contracts, which were disclosed in a September 2007 letter to investors, emphasis FT Alphaville’s:

First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). 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.

If Berkshire does have to pay out, then the insurer is on the hook for up to $37bn. This is a not insignificant figure (more even than Freddie Mac managed to lose in Q3) but there’s already an obvious mismatch here - those contracts don’t come for another 11 years, so the sharp rise in the 5-year CDS contract is more than a little strange.

And if you’re willing to take the Sage at his word, Buffet believes “these contracts, in aggregate, will be profitable'’, according to the letter. There’s also the small matter of Berkshire’s $33.4bn cash pile.

The deterioration of Berkshire’s perceived creditworthiness has suprised investors. Per Bloomberg:

“That’s just so stupid,'’ said Mohnish Pabrai, head of Pabrai Investment Funds and a Berkshire shareholder. The swap buyers are projecting “present circumstances into infinity'’ and concluding Buffett’s bet will cost the company $40 billion, Pabrai said. “It will never happen,'’ he said.

Hedge fund manager Whitney Tilson was so appalled by the CDS movements (”I’ve seen a lot of crazy things in my investment career, but I struggle to think of anything that tops this”) that he issued a five-point rebuttal in an emailed letter to investors, including:

It is CRITICALLY important to understand that the puts cannot be exercised prior to expiration, nor does BRK have to post cash collateral when the indices fall (though BRK has to take a mark-to-market, noncash charge). Assuming Buffett can invest the premium at 7%, $4.5 billion becomes $17.4 billion in 20 years.

People are freaking out about BRK possibly having exposure of $37 billion, but this is the maximum payout if ALL FOUR major world indices were at ZERO 14-19 years from now!

One might say that Buffett was foolish to have written such puts a year ago and ask why he didn’t wait until the market declined before writing them, but it’s doubtful anyone would pay Buffett $4.5 billion (or anything close to it) to buy at-the-money puts today.

Tilson, who maintains a significant position in Berkshire, dismissed the idea that there could be “any hidden derivative bombs on Berkshire’s balance sheet” by highlighting an excerpt Berkshire’s 2002 annual report as an example of how Buffet “thinks about risks” like derivatives:

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons.This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Which, Tilson notes, is exactly what happened to AIG.
Tilson and Buffett appear confident that nothing similar will happen to to Berkshire (which would in fact have to post collateral on some derivatives “under certain circumstances, including a downgrade of its credit rating below specified levels,'’ according to regulatory filings).

But the suddeness and sharpness of these moves suggest there’s more to this than meets the eye. As is inevitably the case when WMDs are invoked.