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What Is Going on with Berkshire Hathaway?

Warren Buffett wrote last year:

http://www.berkshirehathaway.com/letters/2007ltr.pdf Last year I told you that Berkshire had 62 derivative contracts that I manage.... Today, we have 94... [in] two categories.... 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. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk. Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either.... [W]e are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well...

Berkshire Hathaway Credit Risk, Index Puts Are Overblown Worries - Seeking Alpha

Whitney Tilson:

Berkshire Hathaway Credit Risk, Index Puts Are Overblown Worries: I’ve seen a lot of crazy things in my investment career, but I struggle to think of anything that tops this: Berkshire Hathaway’s (BRK.A) five-year credit-default swap spreads have more than tripled in the past two months and now stand at 475 basis points.... [T]he median CDS spread for companies with the lowest investment grade bond rating (BBB-) is 348 basis points.... Berkshire’s CDSs are higher than a wide range of other financial companies [more than 4x Travelers (TRV), 3x JP Morgan Chase (JPM) and well above Citigroup (C), even after Thursday’s stock collapse – the world has truly gone mad!]. A final thought on how crazy Berkshire’s CDS spreads are: What are investors who are buying CDSs on Berkshire thinking regarding counterparty risk? If things get so bad that AAA-rated Berkshire Hathaway goes bankrupt and defaults on its debt, what counterparty is likely to still be standing to pay on the CDSs???....

If one does no analysis, Berkshire’s derivative contracts appear to pose similar risks to those that caused AIG and others to collapse, but in reality, nothing could be further from the truth.... Buffett elaborated on this in the Q3 earnings release....

At the end of the third quarter, we had a liability of $6.72 billion for equity index put option contracts for which we have received cash payments of $4.85 billion. This means our recorded loss to date is $1.87 billion though the first payment that could be triggered would be in 2019.... In the meantime all of the $4.85 billion can be invested by Berkshire....

What about the much larger equity index put option contracts, for which Berkshire was paid $4.85 billion and had suffered noncash “losses” of $1.9 billion through Q3?... Buffett sold at-the-money puts on the four major world market indices at various times over the past few years.... If the indices rebound by 67% over the next 13.5 years... a mere 3.9% annually, then the puts will expire worthless and Buffett can pocket the entire $4.85 billion....

I think it’s very likely that the indices will compound at 4% annually from today’s depressed levels, making it unlikely that Berkshire will have to pay out anything on these contracts. And given how much Buffett was paid to write them and his ability to invest the premium he was paid in any way he chooses, it’s even more unlikely that this will be a losing investment. Thus, even knowing what I know today, I think this was a fantastic investment and wish Buffett had written more of these contracts (perhaps he’s writing more today?)...

In this environment, it’s not surprising to us that the stocks of companies with shaky balance sheets, poor business models and/or weak competitive positions are getting clobbered, but Berkshire’s freefall in the past few weeks is certifiably crazy – and a buying opportunity that will long be remembered.

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