Berkshire’s Welcome Downgrade

March 13, 2009

Well, that didn’t take long. I speculated yesterday that Berkshire Hathaway would be the next company to be downgraded from triple-A; I didn’t think that it would happen within a matter of hours. But Fitch went ahead and did the right thing:

“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,” the ratings agency said in its statement on Berkshire.
Those exposures include Berkshire’s equity investments, as well as its holdings of derivative contracts tied to equity and credit markets, Fitch said.
Fitch is the first major credit agency to cut Berkshire’s ‘AAA’ rating.

"First", here, has the same meaning as "my first wife", or "the First World War": it implies the existence of a second — and, in this case, a third. Berkshire has often been described as the world’s most successful hedge fund; that’s fine, but hedge funds don’t have triple-A ratings, and neither should Berkshire.

Fitch also made a good point about what you might call "Buffett risk":

Fitch also noted Berkshire remains too closely linked to Mr. Buffett to merit a ‘AAA’ rating.
“Fitch views this risk as unrelated to Mr. Buffett’s age, but rather Fitch’s belief that BRK’s record of outstanding long-term investment results and the company’s ability to identify and purchase attractive operating companies is intimately tied to Mr. Buffett,” it said, referring to Berkshire.

Interestingly, however, if and when S&P and Moody’s follow Fitch’s lead, the Buffett risk might actually be reduced. Market Movers reader Nicholas Weaver explains:

An AAA-rated company, especially a AAA-rated financial company (AIG, the monolines, GE, Berkshire Hathaway) is naturally tempted to commit ratings arbitrage, and all but Berkshire Hathaway have nearly imploded due to this behavior.
Such arbitrage in the short term greatly enriches management, but in the long term can destroy the company. Basically, the lesson is "A company should have an AAA credit rating only as long as it doesn’t actually borrow much against it!"
Why this hasn’t happened to Berkshire is simple: Warren Buffett and Charlie Munger prevented this from happening through tight corporate controls. The only ratings arbitrage that occurs is on the manufacturing companies Berkshire acquired over the years, which allows these companies to borrow for expansion (everybody) or for customer financing (Clayton Homes) at AAA rates.
And they kept this temptation under control simply because they are such huge shareholders that short-term compensation for them simply does not matter, it is dwarfed by their holdings.
But Buffett and Munger can’t live forever. And thus the question for 5 years hence: how does Berkshire Hathaway the company survive when the management no longer has the rather unique compensation strategy thats currently in place?

The answer is that if Berkshire has already lost its triple-A by the time Buffett and Munger depart, then the ratings arbitrage is by definition impossible. Shareholders should welcome a downgrade, because it reduces the incentives for Berkshire’s future managers to play silly ratings games.

Reprinted from

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