Berkshire Hathaway's Derivative Play

[GOODYRL]

Berkshire Hathaway's Derivative Play

by: David Enke May 05, 2008 | about stocks: BRK.A / BRK.B    

 

David Enke

In its recent first quarter statement, Berkshire Hathaway (BRK.A) released that it has bought derivatives on various stock indexes that were set to expire between 2019 and 2028. The indexes of interest for Berkshire include the FTSE, Euro Stoxx 50, Nikkei, and S&P 500. The derivative plays included multi-billion-dollar positions that involved selling puts on the indexes. The report has Berkshire with $4.5 billion in premiums and $4.6 billion in liabilities at the end of 2007.

Apparently, Berkshire is not done and is continuing to increase its position, where premiums increased by $383 million after selling additional puts. This increases its derivative liabilities to $6.2 billion. In Q1 the positions went against Berkshire, causing it to record a loss of $1.2 billion. Given the long expiration dates, the losses appear to be mainly mark-to-market accounting losses, and not positions that have been closed. Each of the indexes that puts have been written against has been down for the year.

Of interests is that since $4.5 billion was generated in premiums in 2007, the notational value of the assets (indexes) themselves could be estimated to be in the range of $70-$100 billion. While Berkshire's insurance business has surely used derivatives to hedge risk, this direct speculative move into derivatives is both surprising and understandable..

On the one hand, Buffett has repeatedly talked about derivatives being "financial weapons of mass destruction," and something that has contributed to the current problems we are experiencing in the markets. Granted, there is a big difference between writing naked puts and writing a CDO-squared, where counterparty risk is not only huge, but often unknown. Nonetheless, it is interesting.

On the other hand, Berkshire's large insurance businesses have been providing a large float for Buffett to redeploy. The writing of naked puts will now provide extra income that can be put to work, albeit at a different level and degree of risk. Furthermore, the move signals that Buffett may feel that the market correction is over, and that the indexes are going up. If you believe this, as Buffett apparently does, then selling puts would seem more logical, and would also give you the cash you need to begin buying relatively cheap assets that you expect will be moving up from recent lows. Buffett has said as much, stating recently that he believes the worst of the credit crisis is over for Wall Street and the markets, even though individuals will still feel pressure. With the recent moves, Buffett is certainly putting his money where is mouth is, but is taking on more risk.

Finally, in addition to market direction bias, this move may also be giving us clues about the Berkshire insurance business, and the level of float that Berkshire needs and expects to receive in the future. Time will only tell how all this plays out for Berkshire and its shareholders.

Disclosure: Long BRK.B

http://seekingalpha.com/article/75744-berkshire-hathaway-s-derivative-play

 

[oec2000]

Is it time to load up (SELL) on naked puts ?

 

Given where mkts are, the risk/reward characteristics of going long are, imo, much better. There are so many potential multibagger opportunities - it doesn't seem logical to me to enter a trade where your gain is limited to a fraction of the risk and capital you'd have to tie up to sell the put.

 

 

[arbitragr]

so long as you have the capital to cover if things go south any more. BRK can do it b/c they have the capital ratio to cover.

 

old adage rings true once again;

 

the market can stay irrational longer than you can stay solvent.

 

Things I thought would never happen have happened in this market environment; GE falling to 8 bucks, WFC falling to 10 (and thereby falling below WEB's original cost basis!!). BRK falling below tangible book value.

 

In the middle of 2008 I thought credit spreads were huge, and thought they were going to re-correct and come back since they were wider than both the LTCM period and 2002 downturn. Turned out they blew out even wider ... 2x as much!! I agree that now is probably less likely to produce even more chaos, however it's all probabilities and you never just "know" ... probabilities might say 10-20% chance of going south even more.

there are still people who are bearish about the current market, Shiller thinks p/e ratios should mean revert even more etc etc. People like howard marks still thinks we haven't reached bottom unless default rates reach 10% at least ... they're only about 6-7% roughly (I think).

 

But that's the whole challenge of being a professional investor. You have to do your research and make your bets. You get it right, you win. Get it wrong, you lose ... or ... your career could end.