The derivatives game

The unpredictability of earnings volatility due to MTM gains and losses is characteristic of any business that has a high derivatives exposure.

Every semi-colon in Warren Buffett’s annual letter to Berkshire Hathaway shareholders is routinely placed under the microscope. This year, the letter was even more eagerly awaited than normal. The Sage of Omaha delivered a pithy explanation of how he sees the crisis evolving.

Berkshire Hathaway (BH) has just recorded the worst-ever year in its 44-year history. It was impossible for one of the world’s largest financial conglomerates to escape unscathed as US markets lost 40 per cent.

In addition, the chairman took responsibility for what he called “one major error of commission” and several errors of omission. Buffett took long positions in the oil and gas markets when crude was zooming up. That led to the loss of several billion dollars as prices collapsed. Buffett also claims that he failed to act quickly when the crisis became apparent.

Buffett’s belief is that the government bailouts were justified. While these will have “unforeseeable and unwelcome” consequences, the alternative was catastrophe. Though his long-term prognosis is that “the US has its best years ahead”, he believes that 2009 is likely to be horrific.

As usual, he will continue to seek beaten-down assets. BH has already made a few long-term acquisitions and reworked its portfolios to take advantage of crisis-valuations. He also warns against riding the bubble in the US bond market for much longer. The implication is that he thinks there will be a sharp rise in US$ yields if his predictions of a US bond market collapse come true.

The 20-page letter devotes a large section to derivatives. After delivering his usual homily against complex derivatives, he explains why BH continues to use them and how he has tried to bullet-proof BH’s exposure. He also offers a simple, convincing explanation of why he thinks the Black-Scholes formula is absurd for long-term premium pricing.

Despite his splendid impersonation of a simple small-town businessman, Buffett has the training, the savvy and the experience to understand derivatives. He is his own “chief risk officer” as he terms it. BH is the biggest insurance/ reinsurance operation in the world and general insurance is essentially about complex long-term derivatives.

Apart from the insurance business itself, BH has $37 billion at risk as the writer of long-term index puts spread across stock markets in the US, UK, Japan and Europe. These expire at various times between 2019-2028. The premium inflow was $4.9 billion. As Buffett explains, the indices in question would have to hit zero on expiry for all $37 billion to be paid out. If the indices are above strike price on settlement day, BH pays nothing.

BH has taken a mark-to-market loss of $5.5 billion on these positions. It is unlikely that it would be needed to pay this. But in the worst case, a 20-year loan of $4.9 billion for an eventual payout of $10.4 billion would be equivalent to an interest rate of less than 4 per cent.

BH also has an MTM loss of $3 billion on credit instruments where BH took premiums of $3.4 billon. It has a further set of Credit Default Swap (CDS) positions with $4 billion worth of underwriting and annual premiums of $93 million. It has stopped taking CDS positions.

Buffett sees all this in terms of a market-neutral strategy carried out on a titanic scale. By writing derivatives, BH raises what seems to be very cheap or potentially free cash. It invests that money to generate returns that will, hopefully, outweigh potential losses that may accrue at the time of settlement.

This is precisely the way most insurers use their “float”. If the MTM losses do come to pass, the costs are acceptable compared to long-term interest rates. As he points out, the Black-Scholes formula, which BH uses to MTM, offers absurd results in the long-term. Volatility calculations over 15-20 years are completely meaningless and he believes that it overestimates the likelihood of losses for the positions he holds.

But the bets are on a scale that not even BH can afford to get wrong. Very few organisations have the combination of capital adequacy and internal audit systems to manage such massive positions. Analysts will also find the earnings volatility caused by fluctuating MTM losses and gains bewildering. That unpredictability is characteristic of any business that has large derivative exposures.