With all of the inaccurate information being reported about Berkshire’s derivatives exposure, Warren Buffett apparently saw the need to devote several pages of his annual letter to shareholders to explain the situation in great detail. Unfortunately, it appears that most articles on Berkshire’s 2008 results either did not report on the contents of Buffett’s letter or continued to provide misleading or inaccurate information. Perhaps the reporters covering Berkshire are simply confused.
Berkshire reported that it is party to 251 derivatives contracts excluding those used for operational purposes in the energy business. Buffett entered into each of these contracts personally and did so because his assessment of the risk/reward equation was that the contracts were dramatically mis-priced in Berkshire’s favor. The following points from Buffett’s letter are particularly important to understand in order to intelligently determine the true risk profile of the derivatives in the portfolio.
Absence of Counter-Party Risk
Typical derivatives contracts carry substantial counter-party risk. For a derivatives contract to serve any purpose, one must hope that the counter-party will be good to make payment if the terms of the contract call for it. Sometimes the terms of the contract may reach far into the future. One of the main reasons for the government bailout of AIG is that AIG is a counter-party for derivatives entered into with many important financial institutions worldwide. If AIG defaults on these derivatives, suddenly all of their counter-parties could face solvency issues.
With Berkshire’s derivatives, there is no counter party risk because payment is made in advance when the contracts are initiated. This has two benefits. First, the counter-party cannot default because they have put up their obligations ahead of time. Second, Berkshire has use of the funds provided by the counter-party for the life of the contract. This is much like insurance float. The funds are available for Berkshire to use for investment purposes throughout the lifespan of the derivatives contract. At the end of 2008, Berkshire held $8.1 billion of “derivatives float”, as Buffett calls it, that can be used for investment purposes.
Minimal Collateral Requirements
Berkshire has very minimal collateral requirements when the market moves against the company. Most contracts do not require posting any collateral whatsoever. The contracts that require posting collateral are minimal. Even when Berkshire posts securities as collateral, the company continues to earn income from the posted collateral. Only 1% of Berkshire’s security portfolio is currently pledged as collateral for all derivatives exposure.
Equity Puts – “European Style” Options
Berkshire’s equity put option contracts are “European” options and can only be exercised by the counter-party at the date of expiration of the contract. In contrast “American” options can be exercised by the counter-party at any time. Consider the equity puts written by Berkshire at much higher levels. Since they are European options, Berkshire has no cash flow liability because the counter-parties cannot exercise the options until expiration which will not occur for over a decade. If these options were American options, the counter-parties could decide to exercise today and Berkshire would have to put up the cash. This is a key difference all but ignored in the media. It means that the paper losses on the equity puts are just that – paper losses. No cash flow is going to occur for at least a decade, and only then if the index value remains at depressed levels. In the meantime, Berkshire has full use of the premium received for writing the index puts.
Maximum Exposure on Equity Puts: $37.1 Billion …
… But only if the indices on which the contracts are written fall to zero at the expiration of the option! Berkshire must pay the counter-party if the index levels at the date of expiration are lower than the index levels at the inception of the contracts. Since all of the contracts were written at much higher market levels, this means that all of the options are “in the money” for the counter-parties, but they cannot exercise until expiration due to the European style feature of the contracts. The only way Berkshire can lose the full notional value of the contracts is for the indices to fall to zero. Otherwise, the losses will be far lower. If the indices only rise back to the level on the date when the options were written, Berkshire would have no liability whatsoever.
Black-Scholes Marks Make No Sense
Even though the equity puts cannot be exercised until the expiration date of the option (between 2019 and 2028), Berkshire still must “mark” the value of the contracts each quarter. Buffett endorses mark-to-market accounting and I agree with this as well. There are too many opportunities for dishonest managements to cook the books without mark-to-market accounting. However, the process used to come up with the marks is invalid for long dated options. Buffett clearly explains the folly of using Black-Scholes for options expiring more than a decade from now:
The ridiculous premium that Black-Scholes dictates … is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probability-weighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm a century from now.)
In summary, it seems abundantly clear that the market does not understand the nature of Berkshire’s derivatives exposure. This is one reason for the current valuation of Berkshire Hathaway shares. Except for those seeking to liquidate positions in the short run, this can be viewed with an amused detachment. We are witnessing the folly of the market and the madness of crowds when driven into a frenzy of panic.
While the decline in the market indices upon which Berkshire’s equity puts are based has indeed fallen dramatically, unless one believes that such declines are permanent and will persist for the next decade, these are paper losses and must be evaluated as such. Barring a depression even more severe than the Great Depression, it seems like a great stretch to believe that market indices will not be significantly higher than today’s depressed levels at expiration dates between 2019 and 2028. Even if market indices are merely at current levels by those dates, no further paper losses would be recorded and Berkshire would still have had use of the billions in “premiums” that have been paid for the options at their inception. I am not against considering the potential exposure of these options when evaluating Berkshire’s intrinsic value, but the assessment should be based on facts, not the misinformation being reported by most media sources.