Sunday, May 18, 2008

Response to Kass Article

I promised a write-up on Doug Kass’s article on Warren Buffett which several of you have not let me forget. Kass’s word usage in the article is brilliant in creating strong reactions of Buffett followers. As a writer for is that not that what he is supposed to do, to generate greater readership if not irate reactions? So you first must consider his motive when he compares Warren Buffett “style drift” to the “whoring” of Ben Franklin and inferring that his latest annual meeting was somehow akin to Napoleon’s Waterloo. It is nothing more than brilliant word utilization. However, unlike most writers, he has apparently backed up his words shorting Berkshire in March and thus far would have made money on the trade.

So what about Buffett’s style drift? Is it occurring? Is Buffett stepping out of his circle of competency through his increased derivative exposure? Was the poor first quarter indicative of anything? That is what we shall examine.

Let us look at the first two questions as one. Is Buffett experiencing style drift and is he stepping out of his circle of competence by investing in “risky” derivative contracts? First let us consider exactly what a derivative is and what it can be used for. Derivatives are very wide in scope. They can be a simple standard call option on a stock, to a very complicated customized credit default swap on a piece of debt, or even a derivative on another derivative. People buy them mostly for one of two reasons. A) to speculate on price appreciation of their derivative contract or B) to buy insurance on an underlying security you own. A is buying a put on General Electric when you have no position in General Electric because you believe GE will go down and B is buying a put on General Electric because you own GE and want to protect your downside if something goes wrong with the company. I would argue that the proper way to look at such a contract from a sellers standpoint is always looking at it from an insurance contract perspective. One has no idea who is buying the put I am selling but the central question I should ask myself is am I being compensated for the risk of having to step in and provide compensation for the loss if GE goes down. It is the same question an insurance company would ask when selling fire insurance on a house. Am I being compensated enough for taking the risk of having to make payments if the house burns down? As premiums on the derivatives go up and down, the financial dynamics change in whether you should be a seller of insurance or buyer of insurance. What affects the premiums of a derivative contract? You can go deep into option theory but essentially there are two things that affect option pricing. A) The time the option (derivative) has remaining and B) the inherent volatility of the underlying security. Starting in August of 2007 the volatility aspect of the equation for world markets skyrocketed. This changed fundamentally how I approached the option (derivative) market. I wrote in my 2008 annual letter:

In 2006, volatility priced into the market was extremely low causing the options to be extremely cheap. I was a buyer of options, both puts and calls, using these instruments to both hedge and enter into positions. Currently, volatility is at five year highs causing options prices to surge as well. As a result, starting in September of 2007, I became almost strictly a seller of options (both covered and naked options).

This is exactly what happened in 2005 and 2006 with hurricane insurance. Premiums skyrocketed and Buffett stepped in selling massive amount of hurricane insurance. There may be one thing Buffett is even better at then finding solid undervalued companies to invest in and that is pricing risk and selling insurance contracts. Derivatives, those “financial weapons of mass destruction,” have opened a large new world of insurance type transactions for Buffett. Is Buffett experiencing style drift by participating in that murky world? I would argue a resounding no and if anything he may even be better making money in this world than the stock market world. There is a difference in these contracts than say hurricane insurance and that is the accounting. Imagine for a moment that on September 30th there was a category 5 hurricane sitting in the Atlantic headed west. Those hurricane insurance contracts in the hands of homeowners would be more valuable than they were two weeks before. When the books close at the end of the quarter there is no adjustment on the books for the valuation of those insurance contracts even as the probability of claims getting paid out goes up. Maybe the hurricane slams into Florida or maybe it curves north and dies in the northern Atlantic. Either way on the last day of the quarter there is no adjustment to the insurance (“derivative”) book of Berkshire. Now jump to financial derivatives. On March 31st of this year right after Bear Stearns there was huge accounting losses even though no claims were paid. This is exactly what Buffett meant when he has said he would rather take a lumpy 10% then a smooth 8%. By entering into the financial derivative market his returns will become lumpier but my guess is they will be greater than they otherwise would be. Either way this is at the core of his circle of competency.

There have been two major moves by Buffett into these derivatives. One was a couple of years ago when a large investment fund (my guess is some retirement fund) essentially bought puts on the market that lasted like twenty years (I forget the exact number). The strike price was somewhere around 20% below the market’s current price and payments would only be made if at the date of expiration the market was below the strike price level twenty years later. This is nothing more than an insurance contract that a fund thought prudent to buy. My guess is the fund hopes it expires worthless (if you own fire insurance do you want your house to burn down?). These are the type of transactions that General Re (insurance subsidiary of Berkshire) specializes in. The other big push was late in the 4th quarter of last year when Buffett started selling CDS insurance on certain companies. The CDS spreads had blown out to levels Buffett though was ridiculous and stepped in to sell insurance in case the underlying company defaulted. Both of these transactions worked against him in the 1st quarter. Both are likely over time to have extremely large gains.

Is this new found market something Buffett is excited about? I do not think so. Others will use it under the emotion of greed and potentially destroy the financial system. This goes back to the WMD comparison. In fact at the Wesco meeting Charlie Munger (Buffett’s partner) addresses this:

If you ask me, would I give up all of the opportunities of derivative trading to go back to a simpler cleaner world like engineering of yore--I would do it in a heartbeat.

In fact this is the core difference between Berkshire derivative book and MBIA’s derivative book. MBIA losses make them insolvent. Berkshire quarterly losses do not. MBIA made very poor bets to juice returns, Berkshire hopefully made very wise bets even though in the short term it hurts results. MBIA transactions were motivated by greed, Berkshire’s were motivated to take advantage of fear.

So back to the final question, is the first quarter indicative of anything? If it is indicative of anything it is that the results of Berkshire could be lumpier going forward. If they were to make this a large part of their insurance operations, the accounting aspect of it will dictate greater swings in gains and losses quarter to quarter. This will create buying opportunities as Wall St. misunderstands what is happening.

Either way I really think all of this has nothing to do with Berkshire’s drop in stock price. Mr. Kass I believe is missing the causality. My thought of why Berkshire has gone down is because Berkshire in itself was an insurance contract. If I had to invest 20% of my portfolio in financials what better place to do so as the financial world was blowing up than in Berkshire? After it became clear that the Fed would bailout the financials, those fair weather buyers started moving money out of Berkshire into other financial companies seeking higher risk and higher return. Berkshire's stock price may go nowhere for the next couple of years but I would strongly bet the intrinsic value will continue to increase.


Travis said...

Do you follow/like/dislike Primus Guaranty (PRS)? They do the same thing Buffett does with CDS except they do it for a living. If you don't think defaults on investment grade companies will sky rocket (which maybe you do?), you should look into them. They focus mostly on single name IG, the only risk really is a downgrade of the underlying companies to CCC, which qualifies as a credit event, in which case counterparties can demand their money. GAAP book is negative from the MTM losses, economic BV is $9 per share, and unearned premiums are around $17 per share, for a $4 stock...

Market Seer said...

Don't follow it. Do they long and short it? Any company that looks like they started doing this in 2005 makes me nervous. I do not think the vast majority of investment grade companies will have problems but a few will have major problems. Very interesting. Thanks for bringing it up. FFH has big CDS position as I am sure you know but there bet is it is going to get worse.