In the first nine months of 2013, Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) made derivative gains of $1,361M, according to its earnings release. That may be minuscule in the context of its operating earnings of $11,363M in the same period, but is certainly not to be sneezed at.
You’d be forgiven for a double take at those figures. Buffett…and derivatives? People would generally assume that the author of that very expressive quote on derivatives (“financial weapons of mass destruction”) would keep his distance from them.
It appears that is not quite correct – not only does Buffett have the loathsome things on his books - he actually made money on them. How he does that is explained very well in an article “Why Does Warren Buffett Make Money?” written by Pablo Triana, and published by the Corporate Finance Review in its November/December issue.
Weapons of mass destruction
But first, some perspective on Buffett’s “weapons of mass destruction” comment, (made in Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)’s 2002 Annual Report), which was based on his apprehensions of the following features of derivatives:
- “Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them.”
- 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.”
- “Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others…Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.” (Another relevant Buffett gem: “Derivatives are like sex. It's not who we're sleeping with, it's who they're sleeping with that's the problem.”)
Derivatives for float
Triana’s analysis of Buffett’s success with derivatives reveals that this too is based on the legendary investor’s predilection for free float, or access to cheap or free funds that can be leveraged with stock-picking prowess to achieve super-normal gains.
The article says Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) hiked up its exposures to equity put contracts and credit default obligations from 2004 onwards until they more or less leveled off in 2008/2009, as per the chart below:
The equity put options were all European options that were exercisable only on maturity between September 2019 and January 2028, and were struck at the money, thereby “affording a very tasty premium for Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B), as these options are very close to having positive intrinsic value.” The credit contracts covered high yield and IG corporate credit and state/muni risks.
No more payouts on the horizon
The author estimates that losses on the derivatives holdings are about $3B. And it gets better. He says, “when we take into account that, barring any desperate request by a counterparty to unwind a trade (together with Berkshire’s acquiescence to do so and incur the cost of buying back the exposure), no further loss payouts can happen before expiration of the only two remaining positions, the equity puts and the state/municipalities credit default obligations that mature in the pleasantly distant 2019–2054 period.”
Obviously, Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) has done very well, but the crucial takeaway from this article is the portfolio selection criteria that Buffett employed in these derivative trades.
Triana says the portfolio had the following outstanding features:
- For the most part it was devoid of counterparty risk.
- Berkshire got away with very light collateral terms on these contracts, so margin calls could be expected to be of a minimal size.
- It afforded Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) substantial and long-lasting float.
- Timing was impeccable: Notional amounts of equity puts and CDOs on the books explode upwards in 2007 and 2008, a period of panic and over-reaction. “Global equities and American credit happened to be two asset classes that concurrently and suddenly went out of control. And Buffett dutifully stepped in to monetize that chaos,” says Triana.
If we hark back to what Buffett said in the “weapons” paper, it becomes clear that he was able to structure a massive derivatives portfolio that gave him his beloved float, without the baggage of counterparty risk and inconvenient collateral demands.
Earnings volatility…what’s that?
Another crucial point the author makes is that Buffett’s stature allowed him to explain away the earnings volatility that necessarily came along with the derivatives positions. Lesser mortals would have succumbed to shareholder protests in this regard.
The author puts it nicely: “Buffett enjoys god-like stature with his shareholders and has built a career on long-term focus. “Temporary” setbacks, including very large ones, may thus not turn them into ferocious critics. Not everyone may be shielded from criticism in such a way.”
Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) enjoyed an average annual float of $6B from the derivatives trade. It would have paid $10.5B had it borrowed the same amount in 2004 at an average annual interest rate of 5% for a 15-year maturity. Instead, it has only paid up about $3B in losses on these positions so far, and according to the author, no further payments are likely until 2019.