Fitch Ratings has downgraded Berkshire Hathaway’s Issuer Default Rating to AA+ from AAA and downgraded Berkshire’s senior unsecured debt rating to AA from AAA. Fitch has affirmed the AAA rating on Berkshire’s insurance and reinsurance subsidiaries. The outlook for all rated entities is currently “negative”. The press release (ironically distributed by BusinessWire, a Berkshire Subsidiary), may be found at this link. Let’s take a closer look at the reasoning employed by the Fitch analyst to determine if this action is warranted.
Macroeconomic Factors Cited
It appears that Fitch has at least partially based this action on broad macroeconomic factors and has made a rather broad brush statement indicating that ‘AAA’ ratings are “not appropriate” at the holding company level for financially oriented enterprises in the current “stressful economic environment”. It is interesting to note that the macroeconomic situation has been “stressful” in the extreme for the past six months, so the report is not exactly timely in these observations:
Today’s actions are part of a broader review of insurance and financial services company ratings being conducted by Fitch, which includes taking a fresh look at various risk factors and criteria application in light of the current stressful economic environment. Related to this ongoing exercise, which has resulted in numerous insurance and other financial services sector downgrades in recent weeks, Fitch believes that ‘AAA’ ratings are not appropriate at the holding company level for financial-oriented enterprises given significant market volatility and correlation of risks under stress, recently observed throughout the global economy.
Derivatives Exposure Cited
Fitch specifically cites Berkshire’s derivatives contracts as a factor in the downgrade. I believe that Berkshire’s derivatives exposure is widely misunderstood and poses no liquidity concern whatsoever due to the nature of the contracts. The vast majority of Berkshire’s derivatives carry no counterparty risk, cannot be exercised by counterparties for over a decade, and are being valued by a model that recognizes mark to market gains and losses but no cash flow consequences. Nevertheless, the Fitch analyst is concerned:
With respect to BRK, 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. Such exposures include large, concentrated equity investments, as well as exposure to the equity and credit markets through various derivative contracts. Fitch views BRK’s investments in a wide variety of retail, service and manufacturing companies as mitigating this exposure somewhat, but Fitch does not view BRK’s degree of diversification as sufficient to offset these concerns at the ‘AAA’ level.
While this initial statement seems to indicate significant concern and misunderstanding, it is interesting to note that later in the report, the analyst does outline the actual terms of the derivatives and the nature of the contracts:
While the contracts’ recent mark-to-market losses are large, the agency believes that the ultimate economic effects, while uncertain, are likely to be significantly less than indicated by the marks. Favorably, the equity index put contracts were generally written with strike prices equal to the then current index value, had a weighted average maturity of 13.5 years at YE 2008, and are exercisable only at maturity. The CDS contracts appear to be well-managed with reasonable contract and per issuer limits. Additionally, few of the contracts have collateral positing requirements. At YE 2008 BRK had posted $550 million of collateral related to these contracts, a small amount for a company with BRK’s liquidity profile.
It is difficult to reconcile the analyst’s concern about the derivatives noted early in the report with the later paragraph that indicates a clear understanding of the true nature of the derivatives risk.
Key Man Risk
The Fitch analyst mentions “long standing concerns” about ‘key man’ risk related to Warren Buffett noting that the concern is unrelated to Mr. Buffett’s age but related to his unique ability to generate outstanding investment results and find acquisition opportunities. While no one can argue with the fact that Warren Buffett is a tremendous asset to Berkshire Hathaway and that equity holders could suffer in the future if the next executive in charge of capital allocation is not effective, it is a big stretch to claim that Berkshire’s debt holders would suffer a higher risk of default. The next Chief Investment Officer will not be as effective as Warren Buffett, but he or she will be highly competent and personally selected by Mr. Buffett. Even if this executive is merely average, it is difficult to see how debt holders would suffer.
Berkshire Insurance Subsidiaries AAA Reaffirmed
While none of the headlines in tomorrow’s papers will reflect this detail, Fitch did reaffirm the AAA ratings for Berkshire’s insurance subsidiaries with the following comments:
The ‘AAA’ IFS ratings of BRK’s insurance subsidiaries continue to reflect their strong capitalization and competitive positions, and underlying underwriting results. Fitch notes that at their current levels, BRK’s IFS, IDR and senior unsecured ratings continue to be among the highest in Fitch’s rating universe.
Aggressive Deployment of Capital
Fitch notes that Berkshire is likely to continue aggressively deploying capital as economic conditions prompt companies to look for investors with strong balance sheets to provide funding. Fitch cites Berkshire’s “opportunistic” investment style and how this adds “fluidity” to Berkshire’s profile. The analyst goes on to mention Berkshire’s purchase of preferred shares in General Electric, Goldman Sachs, and Swiss Re as well as Berkshire’s new municipal bond insurance operation founded in early 2008.
As any long time follower of Warren Buffett knows, this is the kind of economic environment in which he has created the most long term value for shareholders. Markets like this are perfect for Buffett’s investment style. I find it difficult to understand how Berkshire’s opportunistic use of capital to acquire undervalued assets could harm the interests of bondholders. In any event, this is exactly what equity holders should want Buffett to do in this environment.
My overall impression from reading the Fitch report is that the logic supporting the downgrade is highly suspect. All of the ratings firms have taken a beating in terms of reputation given the very high profile cases where AAA ratings were kept on securities that clearly were impaired. The most famous recent example involved the senior tranches of mortgage backed securities that received AAA ratings and suffered impairments. The rating firms are struggling to stay relevant in this environment. While the ratings firms were blind to risk during the boom years, it seems that they are now equally irrational in terms of risk aversion. It will be interesting to see whether the other ratings firms follow Fitch and downgrade Berkshire in the coming days.