Berkshire’s Puts: Not Such a Great Idea

Andrew Clavell delves into the murky world of Berkshire Hathaway’s equity put contracts, and concludes:

The put owner has been forced into purchasing a lot more credit cover in a nasty cross gamma effect. No wonder BRK’s credit spreads have gone bananas; they will likely remain volatile as there is a short cross gamma hedger out there for the next 20 years.

Moreover, as a result of the credit hedger’s scramble for CDS protection, his mark to market on the original option is potentially worth only half the value had he been fully collateralised.

And you thought Warren Buffett was clever. In hindsight, he clearly never hedged against the impact of creating a short cross gamma hedger.

What’s more, there’s a good reason for the hedger to be cross: thanks to his hedging, his $4.5 billion put is today worth only $5 billion, despite the fall in the market and the rise in volatility. If only he’d got some collateralization, it would be worth $10 billion, and he’d be much more likely to get a hefty annual bonus.

It’ll be interesting to see how the details of how Buffett values the put in his next annual report. Although Berkshire’s CDS spreads make the put worth only $5 billion to the hedger, it’s still a $10 billion liability to Buffett, at today’s volatility levels. What’s more, the $4.5 billion that Buffett received for selling the put is almost certainly worth substantially less than that today, especially if Buffett invested it in Goldman Sachs.

Whitney Tilson still thinks this was a spectacular deal for Buffett:

We don’t know the details of how the puts are structured, but let’s assume the payouts are on a straight-line basis, such that if the indices are down 50% 13.5 years from now – another 17% from today’s levels – then Berkshire will have to pay $18.5 billion (half of the $37 billion maximum). That would be a painful loss, to be sure, but one that Berkshire could easily afford: the company’s earning power today exceeds $10 billion per year and, as of the end of October, its net worth exceeded $111 billion, both figures that will be much higher more than a decade from now.

It’s also important to understand that the loss in this doomsday scenario would not be $18.5 billion minus $4.85 billion because Buffett can invest the $4.85 billion for the entire period. If he earns a mere 7% return for 13.5 years, $4.85 billion becomes $12.1 billion (at a more likely 10% annually, it would be $17.6 billion).

I find this unconvincing, because Tilson ignores the fact that Buffett’s investments are highly correlated with the stock market as a whole. Even the biggest Buffett fan, I think, would have a certain amount of difficulty swallowing the idea that Buffett can get a +10% annualized return on his $4.85 billion over a long period of time in which the stock market falls by 50%.

I don’t think the equity puts come anywhere near to threatening the future of Berkshire Hathaway. But equally, I’m not at all sure they were such a great deal for Buffett: not only did he write puts at the top of the market, but he also invested the up-front premium at the top of the market as well, raising a significant possibility that he would lose money on both the puts and his investments simultaneously.

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