Buffett’s big bet

March 10, 2009

buffett

– Jonathan Ford is a Reuters columnist. The views expressed are his own –

The credit crunch has exposed many one-time financial heroes as having feet of clay. Even the great Sage of Omaha, Warren Buffett has fallen from grace.

The shift in mood has been brutal. The price of shares in the Sage’s investment company, Berkshire Hathaway, has more than halved since last September. Meanwhile, his one-time iron-clad balance sheet now looks rather frail. The credit default swap market is saying that the company’s vaunted AAA rating is so much baloney. Berkshire’s bonds are trading close to junk levels.

The pain is largely self-inflicted. It stems from Buffett’s decision to raise $4.9 billion by writing put options that insured buyers against falls in the value of several large global stock indices, including the S&P 500 and the FTSE 100. These he sold to a range of unknown counterparties between 2006 and the end of last year. The indices in question have slumped putting the Sage potentially on the hook for an AIG-style payout. On a mark-to-market basis, the positions were $10 billion underwater at the end of 2008, giving a $5.1 billion loss after the premium is accounted for.

Why, one might ask, did Buffett make such a bet? This is, after all, the man who has railed in the past against over-the-counter derivatives, describing them as “financial weapons of mass destruction”.

In broad terms, the Sage says that it’s all OK because he, unlike others, knows what he is doing. The options were sold dearly so the chance of a big loss is, he thinks, acceptably low. Stocks tend to rise in line with nominal GDP, especially over the long run. In any case, any payouts only have to be settled when the options expire between 2019 and 2028, which is quite a way out in the future.

Buffett has also argued that the Black-Scholes formula, used to value options, overstates his likely future liability against the puts (an argument that, incidentally, were he really to believe it, would logically lead him to keep writing and selling puts ad infinitum).

So that’s alright then.

Investors have no choice but to trust the Sage if they continue to hold the stock as they don’t have the information to make their own assessment. Intriguingly, many of them seem to be exiting. Perhaps they don’t like the slight whiff of hubris and hypocrisy in the air. It is hard to escape the perception that, for all the talk of value, the Sage sold many of these derivatives mainly to provide a kicker to spruce up the returns from his sagging stock portfolio.

There is also something worrying about selling puts on the stock market and using the proceeds to buy, um, stocks. It’s in effect a double-or-quits bet and if it goes wrong, the Sage is in double trouble. His liabilities will shoot up just as his asset portfolio is shrinking.

But it may also be that investors are spooked by yet another aspect of this trade. Call it the demographic question. Presumably, when Buffett’s counterparties handed him the $4.9 billion in return for his puts, they did so on the assumption that his shrewd investing would ensure that Berkshire would be around to pay whatever it owed under the contracts over the next 10 to 20 years. But by the time the bills arrive, the Sage will be between 89 and 98 years old (depending on expiry date), and his partner Charlie Munger in the even more impressive 95-104 range. God knows who will be running Berkshire then, or indeed whether the stock portfolio will be up to the task of meeting the firm’s liabilities — especially if stock prices fall further than expected and stay down for longer.

This uncomfortable demographic truth may also have occurred to the unknown entities that bought the put options. Under the deal they struck, Berkshire doesn’t have to post more margin if the markets move against it, meaning the put owners are shouldering a hell of a lot of counterparty risk. One explanation for Berkshire’s ballooning credit default spreads then could always be that they are busy buying credit protection on the company for themselves.

32 comments

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Warren Buffet has earned more money in the stock market than any other individual. If past performance is the best predictor of future performance, my money is on the Honorable Mr. Buffet. We have a group of individuals who have lost access to the golden pipeline and they are attacking everyone who is not on their team. Your team lost.

Posted by Marsha Kuhl | Report as abusive

“…Seems like there’s an inordinate amount of “Buffett Bashing” transcending the media recently. It’s hard to understand why…”

You’ve asked the right question. The answer is because he criticized Barack Obama. Jim Cramer got the same treatment this week as you’ll notice.

Both of them are liberal Democrats. Both recently criticized SOME of Obama’s policies. And both have suddenly been subsequently attacked.

Coincidence?

Posted by Tom | Report as abusive

I think Buffet is not only doing things to help his company in the long-term, but also purposely trying to help the US market. Think about it…
1) he bailed out GE and Goldman Sachs.
2) he told everyone that now is a good time to buy stocks (to encourage people to buy).
3) he’s offering insurance to those who need it.
4) He raised the ~$5bil in capitol to buy more stock.
5) He’s been more visible in the media to help bring hope and perspective now more than any other time in his life.

This explains why he’s not acting as cautious as he usually does in the markets… well, that and his famous motto “be fearful when others are greedy. Be greedy when others are fearful”…He’s had to be cautious/fearful for a very long time in the last 20 years of economic boom; now he’s finally letting some greed rip!

Posted by Buffets cool | Report as abusive

I think his put options are his real genius work.

Three stock indices around the world (US, Europe and Japan) would have to touch zero for Berkshire to pay up the money and they have to be in zero on the date of expiry.

There is no further margin requirements.

Believe me, if all the stock indices around the world are at zero, it would probably mean that most of us may not be around to see that happening. And one may not be worried about getting money back for the options.

Posted by Vijay | Report as abusive

I find it laughable when someone in the press writes an article like this.I see another person deftly refered to another article writen in the early 1970′s – the death of stocks- where after Buffetts’ net worth doubled in the next two years. I’d say the hubris is coming from writers who definitely do not understand the topics they write about. I am pretty sure that after 40+ years of killing the market and turning $10k into $50 billion (ok maybe only $30 billion after the last 6 months)Buffett has earned a little lattitude or at least an eternal reprieve from Got Ya articles about his investments. I would like to buy an option that pays off in 2019 and 2028 if Buffett is still thought of as the greatest modern investor and the writer of this article is still an unknown fool, still trying to balance his checkbook.

Posted by Mark Horton | Report as abusive

Can anyone say L shaped recession?

Posted by richard branson | Report as abusive

Corporate profits and the real returns form stocks are under intense pressure as the fallout of a decade or more of unbridled greed and misguided policy works it way through the system. However, this will pass — a point investors forget again and again.

With Buffett’s options only kicking in in 2019, there is plenty of road to run. More important, in the case of stock indices, keep in mind that they are nominal measures. In the case of Europe and the US, in particular, money has been printed hand over fist, with the backdrop being high levels of government debt. When media has stopped panicking about the end of the world, attention will turn to rampant inflation which will sweep stock (and index) prices much higher. Far away from the floor of Buffet’s options.

Adrian (adriansaville.blogspot.com)

mark,
Check this graph to determine what drove the S&P to these levels. Its was the 401k programs launched in 1982 that started the craziness…..Also Buffett made major investments in 1974 (prior to 1982)

http://housingbubblebust.com/Fed/GDPvsHS G.html

Posted by Patrick | Report as abusive

The person with most of the money has the most to lose. A person only has to lose everything once to be wiped out. It is the geometry of trading. Mr. Buffet used his resources early in the development of key companies to create his wealth. This is a sacrifice that must perpetually occur to ensure longterm innovation. We cannot create an environment where creative individuals get pushed out of the markets or cannot obtain funding. Even in nature old growth forests will burn to the ground to make room for saplings. Learn from real master of growth and business – tried and proven from millions of years of experimentation.

Posted by Don | Report as abusive

Agreed with Buffets cool, he is acting on behalf of the US government. After all he has paid very little income tax in his whole life (because he has not sold his investment). Some of his investments are to make money, and some are to keep the economy running (though you can argue that if the economy is dead his investment will be worthless). Also notice who he advertised he invested in: GE, Goldman and Conoco Phillips fits his investing strategy and similar to companies that he had bought out. They have the best (but not necessary smartest) people and the company must be in a smallish field (GE is made out of many fields) where they are expert of the expert. One must also remember that he can not move his portfolio round as quickly as an individual investor–his investments are too large and will affect the general economy so he can not just get in/out of a position as everyone else will follow him.
Now we can not forsee what berkshire will do after buffet’s departure so it is a non-issue.

Posted by rick | Report as abusive

I think its kind of funny that the man that said you shouldn’t buy derivatives got caught by them. I’ve made some very sound investments because of his advice but I don’t just listen to the wizard. When I framed houses we always “measure twice, cut once”.

Posted by Brian Bigelow | Report as abusive

Tell it like it is Greenie.

Posted by Anubis | Report as abusive