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Monday, January 26, 2009

Red Flag I put on Buffett months ago - its gettin wor

I wrote months ago that Buffett makes weird calls and has positioned himself for disaster. His astrology confirms that the once famed investor goes for a rough ride. The worst is yet to come as in aprox. 1 year he will have a disastrous period which could wipe out his fortune. He is low on cash and has 40 bil in index short puts ( eventually he is long the market) - what he always waned of as the weapon of mass destruction 'derivatives could turn out to be his destruction as well. He bets that as the point those options are due he will be fine ( although by statistical means he likely will not be alive - he is 79 and Options start to expire within 20 years). The amazing thing is the timing as he wrote those puts near the highs and at low premium levels due to low Volatility. He is now low on cash and basically the remaining cash is only hypothetical as he needs that as an risk cushion for his derivative exposure. Once we settle by valuation means he has basically no cash left at the lows of Nov. and eventually markets need to go down as a fair value is rather at half of today's levels at current circumstances. Dow can also drop to 1000 in the next years which will bring his equity into negative territory. As the VIX was around 80 that bet might have made sense as the markets were anyway much lower as well - its a bit weird that he made such bets for many reasons. On the other hand that is exactly what Nick Leeson did to cover up some of his losses and we remember what the result was. The only thing which can save this options from disaster is Hyperinflation as the nominal value of stocks would rise with it although worthless in real terms and to some degree that was already the case and part of the rally from 2003 to 2007 as the money supply was already extreme high and with low rates. That created an artificial rally created again by Greenspan together with all the stupid stock buy backs. That was even a bigger scam than the one of Madoff as people were put into the illusion they were getting richer with even the house prices in some areas going through the roof. Hence use the rally we will see in Q1 to get rid of holdings if you are an investor and especially if your retirement is depended on that money (SPX might get as high as 1000 - if you see that sell and never look back). I will alert you as the time comes.


Excerpt 1

http://caps.fool.com/Blogs/ViewPost.aspx?bpid=49971&t=01003216687383103284

Buffett Writing Index Puts

April 29, 2008 – Comments (7) | RELATED TICKERS: BRK-A , SPY , KO

This is the put buffett wrote its on page 47 of the latest 10-k link here.

"Equity Price Risk (Continued)
Berkshire is also subject to equity price risk with respect to certain long duration equity index option contracts. Berkshire's maximum exposure with respect to such contracts was approximately $35 billion and $21 billion at December 31, 2007 and 2006, respectively. These contracts generally expire 15 to 20 years from inception and they may not be settled before their respective expiration dates. The contracts have been written on four major equity indexes including three that are based on foreign markets. While Berkshire's ultimate potential loss with respect to these contracts is directly correlated to the movement of the underlying stock index between contract inception date and expiration, the change in fair value from current changes in the indexes do not produce a proportional change in the estimated fair value of the contracts. Other factors (such as interest rates, expected dividend rates and the remaining duration of the contract as well as general market assumptions) affect the estimates of fair value reflected in the financial statements. The carrying amount of these liabilities was $4.6 billion at December 31, 2007 and $2.4 billion at December 31, 2006. If the underlying indexes declined 30% immediately, and absent changes in other factors required to estimate fair value, Berkshire estimates that it could incur a non-cash pre-tax loss of approximately $2.3 billion."

To me these look like a barrier option with a time constraint, e.g. a put that only that is only active if the price of the index hits a certain strike price within a certain time frame, (like the S&P has to move down 30% in a 1 week period) from what I hear from people Buffett got a bunch of investment banks together that were really scared about a market crash, and wrote the put. Which is smart because if the markets moved more than something like 10% they would shut down trading and we have never seen a one day crash of more than 22.5%. He got something like 4 bil in premium.

What most people do not know or at least talk about is that Buffett obtains most of his stock holdings through selling puts. He got most of his Coca-Cola Holdings this way as many other's. Since he is kind of constrained to buying large cap companies most of which have options traded on them that have decent volume he sells a lot of puts. Also through my own research I know that puts on larger cap companies tend to expire worthless more often than puts on mid cap companies. Also in options theory puts are more expensive than calls in general. There are several reasons for this the main one being that if you want to short a stock you have the pay the dividend's to the person you sell the stock too also you have to pay interest on the borrowed shares, hence puts in theory are more expensive than calls. This kind of works itself out because stocks tend to drop 5x faster than they rise (don't get my started talking about options lol)

Excerpt 2

http://blog.investraction.com/2008/05/buffett-crosses-over-to-other-side.html
Berkshire Hathaway Inc. said Friday its first-quarter profit fell 64 percent because it recorded an unrealized $1.6 billion pretax loss on its derivative contracts, and its insurance businesses generated lower profits.

Berkshire reported net income of $940 million, or $607 per share, in the quarter ended March 31. That's down significantly from the net income of $2.6 billion Berkshire generated a year ago.

Berkshire's chairman and CEO Warren Buffett warned shareholders in his annual letter that the derivatives could make the company's earnings volatile. But he predicted the derivatives will ultimately be profitable.

...

Including the derivative losses, Berkshire's net investment losses in the quarter totaled $991 million. A year ago, the Omaha-based company recorded a $382 million investment gain.

Berkshire's derivatives fit into two major categories. Berkshire will have to pay on some of the contracts if certain U.S. entities default on their credit. Most of the other derivatives will only be paid if the certain stock indices are lower in 15 or 20 years than they were when the contract was written.

Berkshire has received $2.9 billion in premiums on the credit-default derivatives and $4.9 billion on the stock index derivatives.

Berkshire said its operating earnings are a better measure of how the company is performing in any given period because those figures exclude derivatives and investment gains or losses. Berkshire reported $1.93 billion in operating earnings during the first quarter, which was down from $2.21 billion in operating earnings a year earlier.

Berkshire's insurance group, which includes Geico, reinsurance giant General Re and several other firms, contributed $181 million to net income from underwriting new policies. A year ago, Berkshire's insurance companies generated a $601 million underwriting profit.

Buffett has said he expects insurance profits to fall during 2008 because increased competition has driven premium prices down, and a catastrophic loss could further hurt insurance profits.

Emphasis mine.

Now I don't think you should hold Buffett to his word. This is a business where being fickle is a good thing. When circumstances change, you change. Buffett probably meant his mass destruction statement when derivatives were being sold with no idea about risk. But today when risk is priced in, derivatives are much more attractive for a value investor.

Berkshire's business itself is partly insurance. Insurance, I believe, is like a derivative, and that is in effect what Buffett has done - insurance on certain credit not defaulting, and insurance on the index not falling over twenty years.

Not that it is a good idea because I have no idea what twenty years will do and would never write the insurance. You can only come out in two ways - looking like a hero, or totally bankrupt. There's no "in-between". And the number of events, or "black swans" that can happen are ridiculously high - high enough to bankrupt you.

Take the put option Buffett has written on stock indices. Assume a 50% fall from here. He has received about $4.9 billion in premiums. For example a Dow Jones Index put at 12,000, over 20 years, he might get around $1165 per unit, and since they've said around $4.6 billion total premium received, means around 4 million shares which translates to a strike value of $48 billion. Margin requirements for such options are typically $2.5 billion (at 5% margin). That means for an equivalent put option, the margin required is $2.5 billion, for an exposure of $48 billion. If the index falls 50% anytime in the next 20 years, there will be a mark to market loss of $24 billion (though the option cannot be exercised until 20 years later). This $24 billion will be required as a maintenance margin, cash that the company can't technically use. Right now the company has around $36 billion, but if the stock markets hit lows, the cash may be required to purchase or bail out companies - the way Buffett has traditionally grown. Not having that avenue is horrendous - and this is just one index option written - there are other things that require margins (insurance, CDS etc.)

It may sound like a 50% loss is not quite forthcoming or in the horizon, but who can ever see these things? I would want to be on the buy side of that equation, using short term puts as a hedge instead. Far more predictable, and controllable and loss protected.

And that's just the index puts. There are credit derivatives, which assume no credit defaults by the underlying companies. What if that doesn't pan out?

Coming to the rest of the highlighted items. Note carefully - operating income has gone down. Insurance business has gone down in 2007, and is expected to be worse in 2008. Businesses like Amex, Wells Fargo et. al. are due for a subprime hit, and the residential problems will hit the furniture/carpeting businesses. Life isn't going to be easy the next few years.

In a lot of ways, this is huge change in outlook for one of the world's most admired investors. We must wait and see how well he reacts. One lesson though: Do not believe what Buffett says is what Buffett will always do. Because in this business, people change - and for good reason.

Excerpt 3


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