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Buffett's Berkshire Messed-up On Derivative Risks

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http://business.timesonline.co.uk/tol/busi...icle6795403.ece

Berkshire Hathaway underestimated how plunging share prices would hit its investments in derivatives, it admitted to the SEC

Warren Buffett's Berkshire Hathaway underestimated how plunging share prices would hit its investments in derivatives, the legendary stockpicker's conglomerate admitted in letters to the Securities and Exchange Commission (SEC).

America’s top securities regulator revealed the correspondence, exchanged in June, today in regulatory filings today.

The SEC had asked Berkshire Hathaway to provide more information on how it valued billions of dollars worth of derivatives contracts connected to four equity indices around the world.

In a letter to the SEC, Mark Hamburg, the company’s chief financial officer, said that drops of up to 45 per cent in the indices last year were "in excess of our volatility inputs".

But he added that Berkshire Hathaway’s predictions of stock volatility were reasonable over the lengthy terms of the contracts.

Berkshire Hathaway owns 251 derivatives contracts, the best known of which are equity-index put options.

Mr Buffett sold the options when the four indices – the FTSE 100, the S&P500, the EuroStoxx 50 and Nikkei 225 – were peaking in 2006 and 2007. He promised to pay buyers of the contracts if the indices were lower at points between 2019 and 2028 than they were at the time the contracts were arranged.

The contracts had caused a decline in Berkshire Hathaway’s profits for six consecutive quarters before the company’s net income rebounded by 14 per cent in the second quarter of this year to $3.3 billion.

Berkshire Hathaway's derivatives losses shocked investors because Mr Buffett, called the Sage of Omaha for his clever investments, had previously derided the contracts as "weapons of financial mass destruction".

So they didn't stress test enough then? Could be a very expensive contract for Buffett then?

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http://business.timesonline.co.uk/tol/busi...icle6795403.ece

So they didn't stress test enough then? Could be a very expensive contract for Buffett then?

They could be.

His argument is that the options pricing models implicitly assume that you can only earn the swap rate on the premium that you receive upfront for selling the option and that he can earn much more than that over the life of the deals which means that people have given him way too much upfront premium for the risk that he has taken.

I recall that he doesn't have to post collateral against the positions while it is very likely that his counterparties do which means that as stock markets sell off, the net liquidity position of the market worsens. This is what I call a "wrong way round" correlation. Berkshire has increased systemic risk.

I assume that there is a downgrade position in Berkshire's CSA which means that if Berkshire gets downgraded and stock markets sell off a lot (the two are probably highly correlated), they will suddenly face a massive collateral call that they might struggle to fund. For all of his bluster, it amazes me that Berkshire has the same structural problem in its collateral arrangements as AIG and could go the same way.

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They could be.

His argument is that the options pricing models implicitly assume that you can only earn the swap rate on the premium that you receive upfront for selling the option and that he can earn much more than that over the life of the deals which means that people have given him way too much upfront premium for the risk that he has taken.

I recall that he doesn't have to post collateral against the positions while it is very likely that his counterparties do which means that as stock markets sell off, the net liquidity position of the market worsens. This is what I call a "wrong way round" correlation. Berkshire has increased systemic risk.

I assume that there is a downgrade position in Berkshire's CSA which means that if Berkshire gets downgraded and stock markets sell off a lot (the two are probably highly correlated), they will suddenly face a massive collateral call that they might struggle to fund. For all of his bluster, it amazes me that Berkshire has the same structural problem in its collateral arrangements as AIG and could go the same way.

Great post. Very nice.

I agree, one-way CSAs as I said in another post are v dangerous.

I don't think that Buffett will end up paying out on these contracts though, they are pretty safe unless the world falls apart even more than it did the last few years. The only reason he got killed on mark-to-market recently was the gigantic spike in volatility that pushed the price of the contracts he had sold up so much. Most of that excess has already traded out of the market.

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I think he wrote the contracts on the basis he'll be dead anyway by the time they would have to pay up - but he'll be able to take his share of the money now.

City risk reward at its best. The City gets the reward...you know the rest.

Buffett is not stupid.

EDIT: Wonder if he got his longevity calculations right?

There it is again .....that ol' devil called ego.

Which is why I think we'll have years, if not decades, before 'we' finally discover that all those pension and insurance

funds are worth fook-all.

We have to wait for all the fookers who caused the mess to either

a) own up

or

B) die

I think I know which option we'll be waiting for.

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I think he wrote the contracts on the basis he'll be dead anyway by the time they would have to pay up - but he'll be able to take his share of the money now.

City risk reward at its best. The City gets the reward...you know the rest.

Buffett is not stupid.

EDIT: Wonder if he got his longevity calculations right?

I think he wrote the contracts based on the basis that markets trend upwards over time. He also made some shrewd (so far) investments with the proceeds - Goldman etc

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Great post. Very nice.

I agree, one-way CSAs as I said in another post are v dangerous.

I don't think that Buffett will end up paying out on these contracts though, they are pretty safe unless the world falls apart even more than it did the last few years. The only reason he got killed on mark-to-market recently was the gigantic spike in volatility that pushed the price of the contracts he had sold up so much. Most of that excess has already traded out of the market.

The terminal values of the puts that he wrote are a consideration. I also agree that the mark to market of the deals is massively less bad now than they were just a few months ago.

The very fact that he wrote them and the nature of his CSAs could be enough to push him over the edge depending on what happens between now and the expiration of the puts. The path could kill him even if the destination doesn't.

I really like a lot of what Buffett does and the way that he thinks about things but I fear that hubris might prove to be his downfall. His actions implicitly say that he thinks that he is better and cleverer than everyone else. While this appears to be true on average, it only takes one big mistake to undo all of his great work to date.

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I really like a lot of what Buffett does and the way that he thinks about things but I fear that hubris might prove to be his downfall. His actions implicitly say that he thinks that he is better and cleverer than everyone else. While this appears to be true on average, it only takes one big mistake to undo all of his great work to date.

Well, let's face it there is a big difference between always being right, and being big enough/arrogant enough to have 1-way collateral agreements that allow you to dodge all the usual rules of mark-to-market.

It totally gets around the whole issue of "the market can remain irrational longer than you can remain solvent".

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Tell that to a man living in Tokyo.

Yep, if you want to know what the FTSE and Dow Jones are going to be doing over the next 10-20 years check out this graph my future self emailed me:

nikkei225.png

post-21200-1250240662_thumb.png

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They could be.

His argument is that the options pricing models implicitly assume that you can only earn the swap rate on the premium that you receive upfront for selling the option and that he can earn much more than that over the life of the deals which means that people have given him way too much upfront premium for the risk that he has taken.

I recall that he doesn't have to post collateral against the positions while it is very likely that his counterparties do which means that as stock markets sell off, the net liquidity position of the market worsens. This is what I call a "wrong way round" correlation. Berkshire has increased systemic risk.

I assume that there is a downgrade position in Berkshire's CSA which means that if Berkshire gets downgraded and stock markets sell off a lot (the two are probably highly correlated), they will suddenly face a massive collateral call that they might struggle to fund. For all of his bluster, it amazes me that Berkshire has the same structural problem in its collateral arrangements as AIG and could go the same way.

I dont understand why Buffett's counterparties would need to post collateral if they have given him cash up front?

You dont need collateral when you have a bet at the bookies.

And what does CSA stand for?

Looks to me as if the US government is trying to engineer some price rises, in the hope of inflating away some of that debt the economy is groaning under. If they succeed, WB will be on the right side of the bet, again.

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I dont understand why Buffett's counterparties would need to post collateral if they have given him cash up front?

You dont need collateral when you have a bet at the bookies.

And what does CSA stand for?

Looks to me as if the US government is trying to engineer some price rises, in the hope of inflating away some of that debt the economy is groaning under. If they succeed, WB will be on the right side of the bet, again.

No, No, he should be posting them collateral rather than the other way.

CSA = credit support annex. http://en.wikipedia.org/wiki/Credit_Support_Annex

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Tell that to a man living in Tokyo.

EDIT: But that isn't the point I was in fact making. I was making the point that whilst in all likelihood the bet looked a very good one, even if it failed he wouldn't really care and therefore, why not?

"Tell that to a man living in Tokyo."

Compare PEs at the peak. IIRC Nikkei was ~200.

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I dont understand why Buffett's counterparties would need to post collateral if they have given him cash up front?

You dont need collateral when you have a bet at the bookies.

And what does CSA stand for?

Looks to me as if the US government is trying to engineer some price rises, in the hope of inflating away some of that debt the economy is groaning under. If they succeed, WB will be on the right side of the bet, again.

Let's pretend that Goldman bought the puts from Berkshire.

In all likelihood, Goldman would have sold puts (maybe shorter dated etc) on to the street as a hedge against the puts that they have bought from Berkshire. They are likely to have a standard two way CSA with the street counterparty so they have to post collateral to their street counterparty as the market declines even though they aren't receiving collateral from Berkshire.

This collateral has to be funded. In times of stress when collateral requirements rise, funding becomes difficult and expensive which increases systemic risk. This is a material risk in the market which arises from the collateral arrangements rather than from the derivatives themselves.

CSA stands for Credit Support Annex. It is an addendum to the ISDA Master Agreement which defines the collateral arrangements between the two counterparties including things like downgrade provisions, minimum transfer amounts, eligible collateral and threshold amounts.

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