Friday, August 17, 2012

Berkshire Hathaway's Derivatives Portfolio

A follow up to this recent post on Berkshire Hathaway's (BRKa) derivatives portfolio and its impact on the company's earnings.

Warren Buffett has said that Berkshire's derivatives now largely fall into two categories: Those tied to equity market indices and those tied to high-yield bond indices.

All these contracts provide lots of interest-free float to Berkshire.

So they are very insurance-like and crucially require that little or no collateral need to be posted. These have worked out for shareholders for the simple reason that they were priced right in the first place for the risk.

Buffett has explained, in some detail, the Berkshire derivative positions in past shareholder letters. Here's what he wrote in the most recent letter:

Our insurance-like derivatives contracts, whereby we pay if various issues included in high-yield bond indices default, are coming to a close. The contracts that most exposed us to losses have already expired, and the remainder will terminate soon. In 2011, we paid out $86 million on two losses, bringing our total payments to $2.6 billion. We are almost certain to realize a final "underwriting profit" on this portfolio because the premiums we received were $3.4 billion, and our future losses are apt to be minor. In addition, we will have averaged about $2 billion of float over the five-year life of these contracts. This successful result during a time of great credit stress underscores the importance of obtaining a premium that is commensurate with the risk.

Charlie and I continue to believe that our equity-put positions will produce a significant profit...

Buffett gave an example in the 2008 letter to help better understand the "equity-put" portfolio:

To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 – down 10% – on the day of maturity, we would pay $100 million. If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In the meantime, the sale of the put would have delivered us a premium – perhaps $100 million to $150 million – that we would be free to invest as we wish. 

Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24, 2028. We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future.

So it's not just that all four equity market indices would have to go to zero for Berkshire to owe the full amount.

They'd also have to do so on the specific termination date of each contract.

When it comes to Berkshire's derivatives portfolio I'm not sure this is always fully appreciated.

What Berkshire ultimately pays, if anything, will be determined by where those indices are on those specific dates. It is then and only then that Berkshire could owe anything and experience more than just a "scorekeeping" loss.

There will certainly be lots of accounting gains and losses reported between now and then for these "equity-put" contracts. There just will be no additional cash paid (other than the already collected $ 4.9 billion in premiums) to or from Berkshire as a result of these so-called gains and losses.*

Let's say all these indices went to zero tomorrow.

Berkshire would, in fact, have a big accounting loss to report but the company would still owe nothing as a result. The only way Berkshire would have to eventually write a big check is if those indices for some reason happen to still be at zero between 2019 and 2028 on the right dates (well, the wrong dates from Berkshire's point of view). During all that time Berkshire will have had the $ 4.9 billion of cash to invest as they choose.

Of course, they don't have to go to zero for Berkshire to end up owing real money. Obviously, the indices may be instead down only somewhat on those future dates and, as a result, Berkshire would owe a proportional amount at that time.

It's also true is that the indices may be higher and Berkshire would owe nothing.

What's not in doubt is that Berkshire will have all that $ 4.9 billion at their disposal to invest during this time.

It all comes down to whether the premiums collected were priced right for the risks. An investor in Berkshire Hathaway has to decide whether Buffett is likely to misprice these contracts and, if so, what are the consequences.

I still think the Derivatives section (bottom of page 16) of 2008 letter does a good job on this subject but you have to read the updates on Berkshire's derivatives portfolio in more recent letters to have a complete picture.

Here's also a post that I did a while back on Berkshire derivatives, if interested.

Buffett also wrote in the latest letter that new requirements on collateral make establishing new derivatives positions less attractive. So expect fewer of them in the future.

I won't miss trying to understand them.

Adam

Related posts:
Berkshire Hathaway: Earnings and the Derivatives Portfolio
Buffett on Derivatives: The 'Chain Reaction' Threat
Munger on Derivatives
Buffett on Derivatives

* As I mentioned in the prior post, the problem stems more from the limitations of the Black-Scholes formula when it comes to very long-term options.
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