Markets at times are rational, efficient, information-processing mechanisms which correctly price asset markets.
And at other times, the market is an idiot.
This struck me - as it does every day looking at my screens - reading this article from Bloomberg.
Warren Buffett's Berkshire Hathaway
Inc. and Jeffrey Immelt's General Electric Co. are being
battered in the market for credit-default swaps, treating both
AAA companies like junk.
Let's put aside GE for a moment, because I think there is some legitimate debate regarding this company. But Berkshire Hathaway a junk credit?
Investors are paying as much for contracts that protect
against a default on the bonds of Omaha, Nebraska-based
Berkshire, which has $25.5 billion in cash, as for KB Home, the
homebuilder that lost money for seven consecutive quarters. The
cost of credit-default swaps on the finance arm of GE and its
$45 billion in cash is about the same as for building materials-
maker Louisiana-Pacific Corp., which posted nine straight
quarterly losses. ...
Swaps on Berkshire have soared 2.26 percentage points the
past two weeks to 5.35 percent a year, CMA data show. That
compares with 4.9 percent annually for Los Angeles-based KB Home.
Berkshire and KB Home priced the same in the credit default swap (CDS) market? Tell me that the market isn't completely nuts right now.
Now, full disclosure, for the first time ever, I purchased Berkshire shares last week. But I would be writing this article even had I not.
There are three issues with Berkshire I see that could spook the market. The first is that the company writes CDS swaps on corporate debt. What is Berkshire's total exposure?
Berkshire in 2008 started writing credit-default swaps on
individual companies, with contracts guaranteeing $4 billion of
debt from 42 borrowers, Buffett said in the letter.
In other words, if every single borrower whose debt Berkshire insured went under, instead of $25 billion in cash, Berkshire would have $21 billion. Berkshire does not need to post collateral on its CDS positions, so there is no threat of a financial company death spiral, as I explain below.
The next issue are the puts Buffett sold on the market.
Buffett has struck deals with firms that Berkshire hasn’t
identified to protect them against declines in four equity
indexes and guarantees on indexes of non-investment grade
debtors that require the company to pay out when there’s a
default.
The derivatives that garner the most attention are the ones Buffett wrote on stocks. However, those options are European options, meaning they can only be put back to Berkshire when they expire, which do so in a decade. So there is no cash liability for Berkshire until that time. Any market-down on Berkshire's books is an accounting one, not an economic one.
Finally, there is the issue of insuring municipalities. States and municipalities are in a great deal of trouble. However, Berkshire entered this market within the past year, and would barely put a dent into the company's cash pile if all the contracts - which are often second and third behind other bond insurers - had to pay out, i.e. if all the municipalities failed.
Near as I can tell, Berkshire has not sold any variable annuities which are hammering the likes of Hartford Financial. Berkshire's insurance risks are primarily the non-financial kind. Have there been any massive earthquakes or hurricanes the past few weeks that I am not aware of?
The playbook for collapse for many financial companies has been
underwrite CDS, not post enough collateral, bond spreads widen, CDS
liabilities rise, CDS prices rise, underwriter's stock falls, spreads
widen further, liabilities rise more, CDS prices rise further,
underwriter's stock falls further, market gets fearful that the
underwriter will have to issue more equity, stock falls further, CDS
prices rise (sometimes with no spread widening of the issuer), ratings
agency downgrades debt because of rising CDS liabilities and falling stock price, underwriter must post more collateral,
underwriter's stock falls even further making it even more difficult to
raise stock, ratings agencies downgrade debt again requiring more collateral be posted, and so on until the stock price has collapsed that it
becomes virtually impossible to raise common share capital from private interests. There is great interest in breaking stocks through this process.
Now, that is not to say that many firms did not deserve to go under. Companies such as Bear Stearns, Lehman, AIG, Countrywide, and many, many others were extraordinarily stupid, and set their fate, even without any help from the derivatives market.
However, this downward spiral of fear can feed on itself.
A lot of traders “are in a position of where it’s sort of
hedge or lose your job,” Backshall said. When GE credit swaps
soared to as high as 20 percent upfront yesterday, “that was
likely driven just by a desk deciding to desperately hedge,” he
said, “rather than a real belief” that the company had a high
risk of defaulting.
This is George Soros's theory of reflexivity, where a negative loop feeds on itself and the perception becomes reality.
This occurred during The Great Depression. A study by an economist at the Federal Reserve found that banks which failed during the Depression were often as financially strong or stronger than banks that did not. This, of course, runs counter to classical economic theory which postulates that investors and depositors are rational economic agents. Rather than processing information in a rational manner, people became scared and pulled their money out of banks, regardless of the bank's financial health.
This is what I believe is occurring now. All deposit-taking institutions and most financial companies are being taken out and shot, regardless of their intrinsic health. Financial companies especially are prone to this irrational reality since they are highly levered institutions and can easily fail.
The CDS market, which is fairly illiquid, facilitates and enhances this process. It too can be irrational. For example, there has been a disconnect in the high-yield market as prices in the cash market were up this year while prices in the derivatives market were down. The difference in return has been 15% in two months. That is enormous. And ridiculous!
Markets can act irrationally. I believe they are now. Always using a market, any market including the derivatives market, as an accurate gauge of financial and economic health is folly as the perception of the market can become the reality itself.
UPDATE - Here is a post from Accrued Interest on problems in the CDS market.
