Friday, November 21, 2008

The Curse of Deleveraging Haunts Warren Buffet’s Berkshire Hathaway

Warren Buffet’s flagship Berkshire Hathaway has been virtually whacked.

Hence some people have been asking, what’s wrong with Warren Buffett? Has the world’s best stock market investor lost his Midas touch?

Berkshire was down about 8% last night, and has been in a losing streak for 9 consecutive days. And is down by about 50% from the peak.

According to Bespoke Investments, ``While nine straight days of negative returns are not too rare for Berkshire (red dots in chart below), the magnitude of the drop is notable. Since November 7th, which was the last day Berkshire finished up on the day, the stock has declined by 29%. This is by far its largest percentage decline over a nine day period.”

So what’s been troubling Berkshire?

The most likely answer: the widening spreads of the company’s Credit Default Swaps.

According to’s Alex Dumortier, ``The five-year credit-default-swap spread hit 440 basis points yesterday. That means the annual cost of insuring $10 million in Berkshire debt against default over five years is $440,000.”

Courtesy of

In short, the cost of insuring Berkshire Hathaway’s debt has soared. The investing public has priced Berkshire’s credit risk as more than that of Republic of Columbia!

Courtesy of Bespoke: CDS Spread: Safest Financial Company No more

Why? According to many reports, the imputed reason for the surge in the spreads had been due to concerns about Berkshire’s exposure to derivatives. The credit swap market seems to imply that Berkshire is on the hook for some $37 billion, which could risk a credit rating downgrade from its “Triple A” status.

And such downgrade may translate to a call to raise collateral supply to counterparties and subsequently impose onerous demand to raise cash.

Nevertheless, Mr. Warren Buffett acknowledges this in his 2002 annual (emphasis mine),

``Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.”

He even discloses Berkshire’s derivatives risk in its 2007 annual report (emphasis mine),

``First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

``The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion.

``The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written.”

Following observations:

-Worst case scenario for the high yield index exposure will be a loss of $4.7 billion. Yet such losses if it were to materialize will arrive at different expiry dates somewhere between 2009 until 2013.

-Losses from put options sold on four stock indices can only be realized upon the expiration of contracts between 2019 and 2027.

To quote Stacy-Marie Ishmael in FT Alphaville, ``People are freaking out about BRK possibly having exposure of $37 billion, but this is the maximum payout if ALL FOUR major world indices were at ZERO 14-19 years from now!”

-Proceeds from sales of put options are at $4.5 billion. If Mr. Buffett manages to make 7% over the same period this would amount to $17.4 billion or nearly half of the assumed worst case scenario.

-Berkshire still has more than $33 billion in cash which if gradually invested in the present environment should, in the words of Dr. John Hussman, “be associated with extremely high subsequent returns.”

-In addition, when does having a substantial cash position become a liability under the present "debt deflation" environment?

-Of course, all these assume that we are looking at the same risk factors as those who are pricing in a credit downgrade.

Moreover, there is the danger of a self fulfilling prophecy which given the extent of the debt unwind, could lead to a reflexive self feeding action: market outcome influencing fundamentals.

All these add up to only one thing, extreme fear associated with the tidal wave of deleveraging.

As I wrote to a client, ``The seemingly insuperable force of deleveraging is simply looking for any standing issues to bring to its knees. And for securities included in markets that have been globally intertwined, there is no escaping its fury. Whether it is stocks, bonds, emerging markets, commodities, currencies, in the face of debt deflation [Harry] Markowitz's Nobel prize from his portfolio diversification or the Modern Portfolio theory seems non-existent, if not a flawed theory.”

So Mr. Buffett looks more likely a victim of contagion, than from a loss of his magical aura.

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