Berkshire’s CDS and Counterparty Hedging

In Barron’s this weekend, Andrew Bary brought up the subject of Berkshire’s credit default swaps, and why they’re trading at such a wide level:

The Street talk is that Berkshire’s counterparties, believed to include Goldman, are worried about their Berkshire financial exposure and are trying to hedge that by buying protection in the credit-default swap market. The cost of that protection last week hit five percentage points — up from a half-point earlier this year, and seemingly absurd for a company that still deserves a triple-A credit rating. Similar protection for Chubb (CB), which has a lower credit rating, costs less than a percentage point.

I’d heard that talk too, but it never made much sense to me. The story went something like this: Berkshire sold its equity puts to investors via Goldman Sachs. Berkshire doesn’t need to put up collateral, but Goldman does. And somehow Goldman is making up for the fact that it’s putting up collateral by buying Berkshire CDS.

Jeff Matthews thinks this smacks of disloyalty on the part of Goldman Sachs, but I can’t quite connect the dots and see why Goldman should be buying Berkshire CDS as its collateral requirements go up.

On the other hand, what if it’s not Goldman at all, but rather the investor who is buying the CDS? That, I think, would make much more sense. Shitting alpha, I think, is closer to the truth here, but his post is quite cryptic, so let me try to expand it a little.

Let’s say you’re the investor who bought the equity puts from Berkshire — and let’s say that although Goldman might have brokered the deal, your contract is with Berkshire directly. As a large institutional investor, you mark your positions to market daily. The puts are part of your portfolio, and whatever value you put on them, that value has surely been rising substantially in recent months.

As the value of those puts rises, so your counterparty risk with Berkshire Hathaway rises as well. So long as the puts are out of the money and stock-market volatility is low, the chances of Berkshire having to pay out on the puts is small, and your counterparty risk is likewise small. But now that the puts are well in the money and volatility is high, the value of the puts has gone up a lot, the chances of Berkshire having to pay out on the puts has also gone up a lot, and your counterparty risk is much higher than it was. After all, there’s no point in paying billions of dollars for puts, if the counterparty you buy the puts from isn’t going to be around to pay out on them at maturity.

Erik Holm reports today that Berkshire’s annual report will include more information than we’ve received in the past on these puts: apparently the SEC demanded "more robust disclosure" on how Berkshire values the contracts, and the report will now disclose "all aspects of valuation". With luck, that will clear up confusion over the volatility numbers that Berkshire is using. I wonder whether Buffett might not take the opportunity, too, to talk a bit about his CDS spreads, and whether their gapping out is a direct consequence of the fact that he doesn’t need to put up collateral against these equity puts. If he did, that would be very helpful indeed.

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