On the face of it, recent activity in Berkshire Hathaway makes little sense. Credit default swaps on the triple-A company were trading at 388bp yesterday, and are somewhere over 450bp today, possibly having risen as far as 560bp this morning. As Bloomberg says,
For the swaps to pay off, Berkshire would have to exhaust its $33.4 billion cash hoard, and Buffett’s decades-long record as the world’s most successful investor would have to come to a cataclysmic end.
That isn’t entirely true, of course: so long as the swaps widen out at all, traders can make money off them even absent an event of default. But given that the CDS is pricing in such a high probability of serious distress, it’s entirely reasonable for Berkshire’s stock to have fallen — it’s now below $90,000 a share, a level not seen since mid-2006.
Even so, Berkshire’s market capitalization, at $139 billion, is still significantly higher than its book value, which was $118 billion as of June 30 and is surely significantly lower now, given the degree to which Buffett’s investments in the likes of Goldman Sachs have eroded. In other words, the stock market is still pricing in growth and profits, even as the bond market is much more pessimistic.
All insurance companies have a certain amount of event risk. But for Berkshire Hathaway the event the company is most worried about isn’t a hurricane or an earthquake — it’s a credit downgrade. Roger Ehrenberg asks the question on everybody’s mind: "If the market continues to push against Berkshire’s credit will a downgrade become a self-fulfilling prophecy?"
A downgrade could be very, very bad for Berkshire, depending on how its collateral agreements are worded. At some point, Berkshire’s counterparties are going to be able to ask it to put up a lot of collateral against the derivatives contracts it has written — not only the CDS contracts, mind, but quite possibly also the long-dated put options it’s written on broad stock-market indices. Such collateral calls could be extremely harmful to Berkshire’s business model — and that’s before taking into account the loss of business at its new monoline subsidiary.
On the other hand, I’m not comfortable with any company — not even Berkshire Hathaway — having a business model which requires a triple-A rating. Triple-A ratings should be the consequence of a company’s profitability, not a cause of it. If Berkshire lost its triple-A and started playing on a level playing field with everybody else, that might be more sustainable, in the long term, than an attempt to shore up the triple-A at all costs. Certainly there’s something very weird going on when CDSs are at 450bp and the credit is still triple-A: one or the other has to be wrong.