Buffett’s big bet
– 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.