Tuesday, September 7, 2010

Buffett on Derivatives

A significant amount of noise in the reported quarterly results is created by Berkshire Hathaway's (BRKa) derivatives portfolio.

Headlines from media coverage only add to the confusion. Derivatives tend to wreak havoc on reported results.

Some things to consider when evaluating Berkshire Hathaway's quarterly report:
  1. Are the risks from derivatives understandable and well managed?
  2. Are the contracts priced in such a way that the "float" provided will favorably impact long-term value creation for shareholders?
If the risks are being well managed and shareholder value is being created that additional quarterly accounting noise is merely annoying.

Understanding the risks within a derivatives portfolio for any financial institution is not easy these days. Here is what Warren Buffett had to say in the derivatives section of the 2008 Berkshire Hathaway shareholder letter (it starts on page 16):

Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks.

Later in the section he explains...

I believe each contract we own was mispriced at inception, sometimes dramatically so. I both initiated these positions and monitor them, a set of responsibilities consistent with my belief that the CEO of any large financial organization must be the Chief Risk Officer as well. If we lose money on our derivatives, it will be my fault.

Our derivatives dealings require our counterparties to make payments to us when contracts are initiated. Berkshire therefore always holds the money, which leaves us assuming no meaningful counterparty risk. As of yearend, the payments made to us less losses we have paid – our derivatives "float," so to speak – totaled $8.1 billion. This float is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time. Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake.

Only a small percentage of our contracts call for any posting of collateral when the market moves against us. Even under the chaotic conditions existing in last year's fourth quarter, we had to post less than 1% of our securities portfolio.


And finally he explains the "equity put" portfolio, the largest of Berkshire's four types of derivatives contracts (~60% of the derivatives "float"):

For us to lose the full $37.1 billion we have at risk, all stocks in all four indices would have to go to zero on their various termination dates. If, however – as an example – all indices fell 25% from their value at the inception of each contract, and foreign-exchange rates remained as they are today, we would owe about $9 billion, payable between 2019 and 2028. Between the inception of the contract and those dates, we would have held the $4.9 billion premium and earned investment income on it.

Looking at the above numbers keep in mind that Berkshire has the following resources to cover the above potential losses:
1) Berkshire Hathaway's operating companies earn $ 8 billion/year in a bad year (ie. Berkshire will conservatively earn ~$ 150-200 billion in cash between now and when all the contracts expire even if Berkshire does not grow...which it will),
2) Berkshire basically never has less than $ 20 billion in cash on hand and another $ 35 billion of relatively easy to sell bonds (and of course another $ 60 billion in equities that you can just ignore as those may not be easy to sell in a major collapse),
3) even if the stock market did happen to go to zero on those termination dates (The way these contracts are structured what matters is the market value on those termination dates, not any date between now and then) Berkshire actually could still afford it.

Considering what it would take to make stocks go to zero, I'm pretty sure things like derivatives contracts will not seem all that important under those circumstances.

Still, no matter how much disclosure he (or any financial institution) provides you still are betting on the judgement of the risk officer/CEO. I think it's unfortunate this amount of complexity has become part of the system (it's well known that Munger wants them banned 100%). Not that long ago you could look at a financial institutions 10-Q or 10-K and not have to wonder about how many ways these things can blow up. It makes all investing in modern financial institutions too much of a leap of faith.

Like most things he does, Buffett doesn't just give derivatives a cursory treatment in the letter. Other bank CEOs should take the time to do the same.

Adam

Long BRKb
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