Superperformance World Movement
Is Warren Buffet Risking It All?
Warren Buffet may be a genius, but his strategy is not without a tremendous risk. Interesting read.
It is just another risk for Buffett
By John Gapper
Published: November 26 2008 19:22 | Last updated: November 26 2008 19:22
Michael Kinsley once defined a political gaffe as the moment “when a politician tells the truth” and is embarrassed by it. By that standard, Warren Buffett’s deal to write $35bn (€27bn, £23bn) of put options on equity markets was a financial gaffe.
On the face of it, Mr Buffett’s gambit looks both unwise and uncharacteristic. Shares in Berkshire Hathaway, his holding company, tumbled last week (they have since recovered) because it is nursing a mark-to-market loss of about $5bn on the derivatives contracts.
In fact, a casual observer might question what Mr Buffett, who once condemned derivatives as “financial weapons of mass destruction”, was playing at when he bet that four equity indexes, including the Standard & Poor’s 500, would not be below their existing level in 2019 to 2027.
Mr Buffett himself conceded the point in his 2006 letter to investors. Such transactions, he wrote, “may seem odd ... Why, you may wonder, are we fooling around with such potentially toxic material?”
The Berkshire Hathaway that we know and admire is a folksy kind of place where Mr Buffett strikes handshake deals to buy big, solid US companies that do things we all understand. They make gum, or run department stores, or generate heat and light for homes, while Mr Buffett lavishes praise on the honest types who manage them.
But selling options is actually typical of how Mr Buffett has funded Berkshire Hathaway since he first acquired an insurance company in 1967. His business model relies on being paid fees – insurance or option premiums – in return for bearing the risk of future losses. The cash bankrolls him to buy shares in, or the whole of, companies such as Coca-Cola or Wrigley.
Any Berkshire Hathaway investor is taking a tiny risk that, one day, Mr Buffett will miscalculate one such bet and the company will be felled by a catastrophic loss. It has not happened so far, but nor did American International Group, another US insurance group, need to be bailed out until two months ago.
That is why credit default swaps on Berkshire Hathaway have traded at high prices as banks and investors have adjusted to the notion, unthinkable until recently, that the company could go bust. The company shows no sign of doing so, but the idea is not entirely fanciful.
In The Snowball, her biography of Mr Buffett, Alice Schroeder records that when he bought the Nebraska insurance group National Indemnity in 1967 to diversify Berkshire Hathaway out of the textile business, “Buffett had figured out a whole new type of business. If National Indemnity made money, he could send those profits out to buy other businesses and stocks.”
Berkshire Hathaway’s funding base has grown steadily since then. It now owns Geico, the car insurer, and General Re, the reinsurer. Its biggest risks are taken by BH Reinsurance, which covers, as Mr Buffett puts it, “huge risks that no other reinsurer is willing or able to accept”, such as hurricanes and earthquakes.
Mr Buffett’s equity options, which he wrote himself, fall into the category of insurance-like funding. He got premiums of $4.5bn for promising to cover the losses of other investors if, in 15 to 25 years, the share indexes have fallen below their level when the contracts were struck.
The $4.5bn is akin to an insurance premium, or float. Berkshire Hathaway can reinvest the cash while waiting to see how much money it eventually has to pay in claims. Its overall float is now vast – it increased from $18.5m in 1967 to $58bn last year, allowing it to make deals such as its purchase of $5bn of preferred shares in Goldman Sachs in September.
“Float is wonderful – if it doesn’t come at a high price,” he has written in several shareholder letters. His point is that Berkshire Hathaway does well as long as it avoids chronic underwriting losses because the float builds up over time and finances the rest of the business.
So far, Berkshire Hathaway’s underwriting standards, and estimates of potential loss, have been strong. In his 2004 letter, Mr Buffett estimated that if there were a $100bn disaster, its share of the loss would “probably be 3 to 5 per cent”. Hurricane Katrina hit the following year and it cost Berkshire Hathaway $3.4bn.
His options will probably work out too. The mark-to-market loss is only just above the premium paid (without counting the investment income on the cash) at a time of historic stress and no actual cash loss can occur for another 11 years.
It raises the question of whether Mr Buffett is as canny an underwriter as Ajit Jain, who runs his catastrophe reinsurance business. Berkshire lost $3.4bn on a physical disaster whereas Mr Buffett is on the hook for a lot more from financial volatility.
It also illustrates Berkshire Hathaway’s vulnerability to a “black swan” loss of the kind that has struck various institutions recently. Mr Buffett’s approach of insuring events he thinks are unlikely to occur is the kind of trading strategy criticised by Nassim Nicholas Taleb, who wrote The Black Swan.
But none of this means we should lose faith in Mr Buffett, as the market briefly seemed to do last week. He has never hidden the risks involved in obtaining cash float; indeed, he has gone out of his way to explain it in his shareholder letters.
We should not be shocked that he is taking on big financial risks. That is what he has always done, and he has proved to be exceptionally good at it for several decades.
So I trust Berkshire Hathaway while 78-year-old Mr Buffett remains at the helm. The only thing that worries me is that he may have a shorter expiry date than his options.
john.gapper@ft.com
It is just another risk for Buffett
By John Gapper
Published: November 26 2008 19:22 | Last updated: November 26 2008 19:22
Michael Kinsley once defined a political gaffe as the moment “when a politician tells the truth” and is embarrassed by it. By that standard, Warren Buffett’s deal to write $35bn (€27bn, £23bn) of put options on equity markets was a financial gaffe.
On the face of it, Mr Buffett’s gambit looks both unwise and uncharacteristic. Shares in Berkshire Hathaway, his holding company, tumbled last week (they have since recovered) because it is nursing a mark-to-market loss of about $5bn on the derivatives contracts.
In fact, a casual observer might question what Mr Buffett, who once condemned derivatives as “financial weapons of mass destruction”, was playing at when he bet that four equity indexes, including the Standard & Poor’s 500, would not be below their existing level in 2019 to 2027.
Mr Buffett himself conceded the point in his 2006 letter to investors. Such transactions, he wrote, “may seem odd ... Why, you may wonder, are we fooling around with such potentially toxic material?”
The Berkshire Hathaway that we know and admire is a folksy kind of place where Mr Buffett strikes handshake deals to buy big, solid US companies that do things we all understand. They make gum, or run department stores, or generate heat and light for homes, while Mr Buffett lavishes praise on the honest types who manage them.
But selling options is actually typical of how Mr Buffett has funded Berkshire Hathaway since he first acquired an insurance company in 1967. His business model relies on being paid fees – insurance or option premiums – in return for bearing the risk of future losses. The cash bankrolls him to buy shares in, or the whole of, companies such as Coca-Cola or Wrigley.
Any Berkshire Hathaway investor is taking a tiny risk that, one day, Mr Buffett will miscalculate one such bet and the company will be felled by a catastrophic loss. It has not happened so far, but nor did American International Group, another US insurance group, need to be bailed out until two months ago.
That is why credit default swaps on Berkshire Hathaway have traded at high prices as banks and investors have adjusted to the notion, unthinkable until recently, that the company could go bust. The company shows no sign of doing so, but the idea is not entirely fanciful.
In The Snowball, her biography of Mr Buffett, Alice Schroeder records that when he bought the Nebraska insurance group National Indemnity in 1967 to diversify Berkshire Hathaway out of the textile business, “Buffett had figured out a whole new type of business. If National Indemnity made money, he could send those profits out to buy other businesses and stocks.”
Berkshire Hathaway’s funding base has grown steadily since then. It now owns Geico, the car insurer, and General Re, the reinsurer. Its biggest risks are taken by BH Reinsurance, which covers, as Mr Buffett puts it, “huge risks that no other reinsurer is willing or able to accept”, such as hurricanes and earthquakes.
Mr Buffett’s equity options, which he wrote himself, fall into the category of insurance-like funding. He got premiums of $4.5bn for promising to cover the losses of other investors if, in 15 to 25 years, the share indexes have fallen below their level when the contracts were struck.
The $4.5bn is akin to an insurance premium, or float. Berkshire Hathaway can reinvest the cash while waiting to see how much money it eventually has to pay in claims. Its overall float is now vast – it increased from $18.5m in 1967 to $58bn last year, allowing it to make deals such as its purchase of $5bn of preferred shares in Goldman Sachs in September.
“Float is wonderful – if it doesn’t come at a high price,” he has written in several shareholder letters. His point is that Berkshire Hathaway does well as long as it avoids chronic underwriting losses because the float builds up over time and finances the rest of the business.
So far, Berkshire Hathaway’s underwriting standards, and estimates of potential loss, have been strong. In his 2004 letter, Mr Buffett estimated that if there were a $100bn disaster, its share of the loss would “probably be 3 to 5 per cent”. Hurricane Katrina hit the following year and it cost Berkshire Hathaway $3.4bn.
His options will probably work out too. The mark-to-market loss is only just above the premium paid (without counting the investment income on the cash) at a time of historic stress and no actual cash loss can occur for another 11 years.
It raises the question of whether Mr Buffett is as canny an underwriter as Ajit Jain, who runs his catastrophe reinsurance business. Berkshire lost $3.4bn on a physical disaster whereas Mr Buffett is on the hook for a lot more from financial volatility.
It also illustrates Berkshire Hathaway’s vulnerability to a “black swan” loss of the kind that has struck various institutions recently. Mr Buffett’s approach of insuring events he thinks are unlikely to occur is the kind of trading strategy criticised by Nassim Nicholas Taleb, who wrote The Black Swan.
But none of this means we should lose faith in Mr Buffett, as the market briefly seemed to do last week. He has never hidden the risks involved in obtaining cash float; indeed, he has gone out of his way to explain it in his shareholder letters.
We should not be shocked that he is taking on big financial risks. That is what he has always done, and he has proved to be exceptionally good at it for several decades.
So I trust Berkshire Hathaway while 78-year-old Mr Buffett remains at the helm. The only thing that worries me is that he may have a shorter expiry date than his options.
john.gapper@ft.com
Comment
About
Badge
© 2009 Created by Dave Guerra on Ning. Create a Ning Network!
You need to be a member of Corpus Optima to add comments!
Join this Ning Network