Berkshire Hathaway - The CDS Market is Irrational

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.

Comments

[psychodave]

"Now, full disclosure, for the first time ever, I purchased Berkshire shares last week."
Congratulations! Welcome to the dark side.
I think this a fine decision. Sooner or later those shares will appreciate to at least 1.6x book value, and that book value, like the S&P 500, will be growing again.

An anecdotal example of a moniker's "psycho" prefix is my sure confidence these swaps are Buffett's idea of providing a sustainable source of profits to Goldman Sachs, in which he has a serious position.

What other company can withstand a serious hit to its stock price and continue blithely on doing business? Shareholders, much less management, would find it intolerable. Buffett is playing to his strength. Reminds me of the more talented lads in Ender's Game.

To buyers of those swaps I can only whisper "Caveat emptor!", and chuckle maniacally.

[dacian]

T., I have absolutely no knowledge of CDS markets. But if your analysis is correct and CDS markets right now are irrational that should allow you to make money when markets will realise they were wrong. Isn't that called an opportunity? If you spot that correctly, you'll make money later.

As about "rational economic agents"; that is theory and it is used in models. But they are just that, models. In real life, people make approximate decisions ("good enough", "I don't think so", etc.); fear and greed is part of that and I think Soros is right.

[alan smithee (nee kerry)]

BRK sold puts on the SPX. That is likely what people see as the big risk there.

[David]

This reminds of a story about BBT (the regional bank). During the Depression many depositors took their money out and put it with the post office because of the perception of safety, even though the rate was low. The post office, in turn, would take the money and deposit it with BBT.

I just bought PG. I don't know why its selling for just 11x forward earnings even though it offers a safe and attractive dividend and good growth prospects. Am I missing something. I dunno. But it seems cheap.

[bill chan]

DOW S&P NAZ have all broken down from the low of Nov 08. What's next?

Stocks are cheap and getting cheaper in the short term.

[bill chan]

The theme of stocks are cheap can be found everywhere, e.g. yahoo today: http://finance.yahoo.com/marketupdate?u
"...The steep losses have pushed the stock market to new multiyear lows, and compressed valuations. At its current level, the S&P 500 trades at a price-to-trailing earnings ratio of 10.0. In 2008, the market's P/E averaged 15.6. Stocks traded at an average P/E multiple of 16.8 for 2007. In 2006, the average P/E was 16.6. In 2005, the average P/E was 17.5. In 2004, the stock market traded with an average P/E of 18.9. The average in 2003 was 19.2. It was 22.3 in 2002. It was 22.9 in 2001, and 27.2 in 2000....."

How to handle cheap stocks: if short term doesn't work, look forward to the long term. Some day, cheap stocks will bottom and go back up.

[Running Amok In Fantasyland]

In B.I. (Before Internet) times, customers would hang around brokerage houses during bear markets. When they stopped hanging around, stocks were cheap.

With the internet, customers are always hanging around. Trying to put value on real estate on the dark side of the moon.