Buffett's Gamble: $40 Billion Bet on Volatility

by: Andrew Mickey November 21, 2008 | about stocks: BRK.A / BRK.B    

Andrew Mickey

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Warren Buffett’s track record is unmatched. His recent bullishness on stocks has been unmatched as well. Over the past few weeks, the market has made him pay for being bullish in a bear market.

Whether it’s justified or not, Berkshire Hathaway (NYSE:BRK.A) has finally started to get hit by the sell-off. On Wednesday, shares of Buffett’s holding company slid 11% and fell another 12% in early morning trading Thursday morning. The most cited reason for the slide was nervousness over Buffett’s recent $40 billion gamble.

You see, Buffett’s not just buying stocks he likes when they’re undervalued. He’s doing quite a bit more. He’s taking advantage of what the market is offering up to investors with the capital and the time to make an absolute killing here. In fact:

So far, Berkshire cut a deal with Goldman Sachs (NYSE:GS) that will likely go down as one of the greatest deals cut during the financial crisis. Whether Warren Buffett’s Goldman Sachs deal works out or not, the risk/reward ratio was, and still is, stacked in Berkshire's favor. It has done a similar deal with General Electric (NYSE:GE) and took some big stakes in a few more companies.

In addition to that, he’s taking full advantage of the Bull Market in Volatility we talked about a month ago. Many investors have used the S&P 500 Volatility Index (VIX) as a gauge of the amount of fear built into the market. In early October, when fear was at unprecedented levels, the VIX was setting new all-time highs.

But the VIX doesn’t necessarily mean it’s time to buy stocks or there’s no more downside left to go. It’s a direct measure of the cost of portfolio insurance. If the big institutional investors, which are the primary buyers and sellers of the S&P 500 Index options, are all demanding insurance against a market panic, insurance premiums are going to be pretty high. That’s what the VIX measures, the cost of insurance.

So what would someone like Buffett who has been in the insurance business for decades do when the cost of insurance is high? He would sell insurance. And that’s what he recently did that has so many investors worried about Berkshire Hathaway.

About a month ago Buffett sold about $40 billion worth of insurance against the four major indices in the world. The European-style options (which can only be exercised on their expiration dates) were written (sold) are against four major international indices including the S&P 500. The options will expire between 2019 and 2027.

It’s reported Berkshire received $4.5 billion cash for writing these contracts. Considering the contracts don’t start expiring until 2019, Berkshire is free to do what it sees fit with the cash.

The short-term impact of being on the wrong side of the put options has caused investors to flee Berkshire shares. After all, they got the $4 billion cash, but if the markets crash, it could be on the hook for as much as $40 billion.

As a result, creditors are getting very worried. Forbes reports in Betting Against Buffett, the credit default swaps (the cost to insure $10 million against a Berkshire default) is now $440,000. That puts the cost of insuring against a default of Berkshire’s top-rated debt right up there with GE, Goldman Sachs, and Citigroup.

In the long run, this all just shows the absolute short-sightedness of Wall Street. It’s a fantastic move over the long run. Berkshire just collected a $4 billion cash infusion which it can use to buy up great stocks very low prices and wait out the next decade.

It may seem like an exotic move to some, but once you actually look at the numbers and risk, it’s actually much more prudent than investors are willing to give Berkshire credit for over the short-term.

As usual, it looks like Buffett scores another big score in this turbulent market and it’s only a matter of time until the investment community realizes it. At this time, if you’ve got a multi-year time horizon and are using a conservative investing strategy that always keeps cash on hand for the enticing opportunity to buy lower, I’d consider starting to look at shares of Berkshire Hathaway.

Over the past decade they have routinely traded at a 40% premium to net asset value. That is a very high premium to pay. It’s much lower now. The fear and uncertainty over Berkshire and the world’s greatest investor’s moves is unwarranted. Either the U.S. is headed for a decade-long depression or these are going to pay off well.

Disclosure: None

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This article has 34 comments:

  •  
    Nov 21 02:39 PM
    Buffet got close to 11.25% ($4.5B for $40B)premium for the insurance he sold. CDS for Berkshire comes out to be ($440K for $10M) 4.4%. Even if Buffest buys CDS for full amount for Berkshire default he makes 6.85 and gets off the hook ! :-)
    Reply | Link to Comment
  •  
    Nov 21 04:12 PM
    Assuming the seller's still viable to make good on those BRK CDS.


    On Nov 21 02:39 PM ThinkRight wrote:

    > Buffet got close to 11.25% ($4.5B for $40B)premium for the insurance
    > he sold. CDS for Berkshire comes out to be ($440K for $10M) 4.4%.
    > Even if Buffest buys CDS for full amount for Berkshire default he
    > makes 6.85 and gets off the hook ! :-)
    Reply | Link to Comment
  •  
    Nov 21 05:06 PM
    Author, read the Berkshire letter again.

    Buffett sold many of these puts when volatilities were much, much lower, therefore he was on the wrong side of the volatility trade. You want to be a buyer of long-dated options as the VIX goes up.

    Buffett has taken a bath on these options.

    Wake up.
    Reply | Link to Comment
  •  
    Nov 21 05:34 PM
    dlaw: They expire TWENTY FREAKIN' YEARS FROM NOW.

    There's no "bath" taken because he's not going to trade in or out of them. Your "bath" is simply he could have written off those same puts for more money now then before. That's like saying he's taking a "bath" because he could have bought a rising stock for the lowest possible price but instead bought it 10$ more while turning down a profit.

    You wake up!
    Reply | Link to Comment
  •  
    Nov 21 05:53 PM
    Muzie,

    The kid is saying that Buffett is profiting from the bull market in volatility.

    In fact, Buffett is GETTING KILLED by the bull market in volatility on an enormous portion of these puts.

    Repeat: Buffett was on the WRONG side of the volatility trade in 2007.

    Do you not get that???


    On Nov 21 05:34 PM Muzie wrote:

    > dlaw: They expire TWENTY FREAKIN' YEARS FROM NOW.
    >
    > There's no "bath" taken because he's not going to trade in or out
    > of them. Your "bath" is simply he could have written off those same
    > puts for more money now then before. That's like saying he's taking
    > a "bath" because he could have bought a rising stock for the lowest
    > possible price but instead bought it 10$ more while turning down
    > a profit.
    >
    > You wake up!
    Reply | Link to Comment
  •  
    Nov 21 06:08 PM
    I think inflation will save Berkshire on this bet.
    Reply | Link to Comment
  •  
    Nov 21 06:09 PM
    BRK shareholders better hope a decade is enough time, it may not be. I think too much money betting on too few places with counter party risk. Wasn't it Warren who said derivatives were weapons of mass destruction? Why not sit tight and wait for the end of the credit crises before acting? Is Warren being influenced by all the recent media attention?
    Reply | Link to Comment
  •  
    Nov 21 07:27 PM
    Muzie wrote: "That's like saying he's taking a "bath" because he could have bought a <b>rising</b&... stock for the lowest possible price but instead bought it 10$ more ...."

    But he sold puts near the peak, apparently, so the "stock" has been <b>falling</b... And there's no guarantee that it will get back up either, any more than the Nikkei has since its peak. Buffet was doing what Taleb Nassim warned against in his two books: collecting what he thought was risk-free "free money."

    He had better hope inflation will save him. So far he's had to "write down" his balance sheet considerably. That counts as "taking a bath."
    Reply | Link to Comment
  •  
    Nov 21 07:36 PM
    dlaw has it right.

    i chuckle at the notion that there is little risk in these trades.

    we're in a liquidity squeeze.

    capital raising is all but impossible unless you have gilt-edged credit.

    the economy is contracting at the most rapid pace in modern history.

    financial markets have tanked

    volatility is the highest in history.

    junk bond yields are approaching historical levels. spreads have never been wider.

    treasury yields are the lowest in recorded history as a consequence of the lack of confidence in our very financial system.

    bank stocks are crumbling...and not just the Cs of the world. or haven't you noticed what's happened to share prices of the "leaders" (i use the term lightly) over he last 2 months...BAC WFC, GS, USB

    insurance stocks with heavy investment portfolios have lost half or more of their market value in recent weeks...not months...weeks. BRK itself has been the latest victim of intense selling.

    maybe BRK overcomes all this and their sale of puts works out as intended. but i'd be willing to bet that buffet would not make the same trade today. the world has changed since he put that position on.
    Reply | Link to Comment
  •  
    Nov 21 07:36 PM
    PS: Even if he's not taking a bath he's underwater--maybe he'll get back to even if a rising tide floats his boat. If not, he'll drown.

    (Don't give up the [i]glug[/i]!)
    Reply | Link to Comment
  •  
    Nov 21 08:13 PM
    PPS: As the option exercise date draws closer, Buffet will have to continue to take write-downs (depending on how much he's underwater), in sync with the increasing likelihood of his having to take a loss.
    Reply | Link to Comment
  •  
    Nov 21 08:13 PM
    PPS: As the option exercise date draws closer, Buffet will have to continue to take write-downs (depending on how much he's underwater), in sync with the increasing likelihood of his having to take a loss.
    Reply | Link to Comment
  •  
    Nov 21 08:29 PM
    About a month ago? You might want to check your dates on that. I believe he sold those puts many months ago, when the indexes were near their peak.

    He needs a 100% return bull market for those puts to not be in the money. Very doable, I agree, but keep in mind the crash in 1932 took some 15 years to return the previous peak.
    Reply | Link to Comment
  •  
    Nov 21 08:36 PM
    BTW, his deal with Goldman and GE wasn't that great. His warrants are well out of the money and his debt is still at risk.

    You can get 9% tax free from select MLP's right now. These are companies with no debt that make money from transportation of energy, not the actually price it trades. I'd go with MLP's like WMZ. I bought it today, yielding over 9% tax free. Can't beat that with a stick.
    Reply | Link to Comment
  •  
    Nov 22 12:11 AM
    'Twenty freakin' years from now' Buffett will in all likelihood be dead. At 78, maybe he's suffering a hardening of the arteries, as they used to say.

    The Sage of Omaha will make more mistakes, lose his marbles (as we all do!) and be politely retired. He's only a man, after all.

    None of that detracts from his greatness, btw.

    Berkshire won't outlast Buffett by 5 years, I'd wager.
    Reply | Link to Comment
  •  
    Nov 22 12:57 AM
    Looks like either we have depression priced into the market or it's hedge funds gone wild and selling everything they can. I'd love it to be the latter, but I'm afraid of the former.

    Berkshire can get severely kicked by those put options even without decade long depression. Five years might be enough, after that stocks would take another 5 years to recover, at least. Great Depression officially ended up in 1942, but stocks didn't return to 1929 high until 1954.
    Reply | Link to Comment
  •  
    Nov 22 02:01 AM
    I agree with you stoneweapon. I have a lot of time for Buffet but I really thihk all of the attention and adulation he's been getting may finally be going to his head.
    Reply | Link to Comment
  •  
    Nov 22 09:55 AM
    Mr. Buffett is seemingly moving towards being the
    new Donald Trump.
    Always in the news and in the future possibly using the bankrupty courts
    to come out on top in the end.
    Not in his make up, but the old saying walk SOFTLY and carry a big stick
    is now more like TALK LOUDLY and burn the stick for firewood !
    Reply | Link to Comment
  •  
    Nov 22 12:28 PM
    Comparing stock levels in the period from now to 2020+ to stock prices in the period from 1929 to 1954 is one of the most insane hobby horses to ride around on. 1929-1954 included the worst depression in our history and the worst war in our history. It also was a time when companies paid much higher dividends and had lower levels of retained earnings/buybacks, lowering stock prices. American had little or no inflation until after WWII, also holding down stock prices (you might have noticed that this has changed). Finally, 1929 was like 1999-2000 for bubbleish peak prices. We've gone sideways for 10 years, which means that if anything we should be comparing today to 1939.

    If stocks aren't higher when BRK's puts expire, what alternate strategies would you retrospectively recommend? Investing in Treasuries at negative real yields and widening credit risk? Buying stocks that go nowhere? Sitting in cash and continuing to pray BRK doesn't get hit with any big insurance claims? A company like BRK has to take stock market risk - that's the whole point of the company! Out of all stock market risks available, the one Buffett chose by selling these puts was a pretty good one. Accounting earnings don't matter to this company, although if they do take the big cash hit all those years down the line it might kill them. It's a cost of doing business - if it wasn't difficult and risky everyone would be doing it.
    Reply | Link to Comment
  •  
    Nov 22 12:33 PM
    Andy,Andy, Andy.........
    Warren Makes a Bet
    And let's close on this note brought to my attention by Bill King.

    "MSN Money's John Markman: Shares of Warren Buffett's insurance holding company are on the ropes this month, plunging 30% in part because the famed investor dabbled in an area of the market he has long publicly derided: derivatives. And due to a tangled web of financial relationships, they may be taking Goldman Sachs shares down with them. Investors are concerned about a $37-billion bet that Buffett made last year that U.S. and world equity values would be higher in 15 to 20 years than they were then, when the Dow Jones Industrials were trading around 13,000. Through his firm, Berkshire Hathaway, Buffett sold option contracts, known as "naked puts" to an undisclosed group of investors for around $4.85 billion, reportedly using Goldman as broker...

    "Because of its solid-gold credit rating, Berkshire Hathaway was not required to put up collateral to make this trade. But now rumors are flying on Wall Street that the owners of the contracts have demanded that broker Goldman Sachs put up collateral for the rest of the amount due. Since the value of the trade could be infinite, the collateral demands are said to be large, and fears that Goldman will struggle to make good on its obligation has panicked shareholders. Indeed one theory making the rounds this week is that Buffett put $5 billion into Goldman at around $125 per share in September not as an investment but to help provide funds for the collateral.

    Reply | Link to Comment
  •  
    Nov 22 02:51 PM
    What I'd like to know is, who is the idiot/genius who took the other side of those options trades, and why? By a simple back-of-the-envelope calculation, the $4.85 billion Puts are now worth $18.5 billion!
    Reply | Link to Comment
  •  
    Nov 22 05:09 PM
    ".... contracts have demanded that broker Goldman Sachs put up collateral for the rest of the amount due. Since the [b]value of the trade could be infinite[/b], the collateral demands are said to be large, "

    How do you figure naked puts to be infinite? Only values of naked calls can be infinite. The underlying of all the world's indices can go to zero if we get hit by a meteor and we all die and the puts will be worth about $40B (who is left to collect it?), but it is more likely the value of the world's indices can go closer to infinity in our lifetime.

    The only downside to Buffet in this trade is that he is a little old and won't be around to reap its rewards, but his charitable trust in B&M Gates foundation will do fine.
    Reply | Link to Comment
  •  
    Nov 22 06:29 PM
    Good point Roger,

    Buffett and Nassim are on a much different wave length. Buffett believes that America will bounce back, his generation of rewarding experience has taught him to trust in the system.

    Nassim simply understands it is impossible to predict this. The problem is just too complex to forecast the outcome.

    I would prefer Simmons over Buffett when it comes to risk management.


    On Nov 21 07:27 PM Roger Knights wrote:


    > But he sold puts near the peak, apparently, so the "stock" has been
    > <b>falling</b... And there's no guarantee that it will get back up
    > either, any more than the Nikkei has since its peak. Buffet was doing
    > what Taleb Nassim warned against in his two books: collecting what
    > he thought was risk-free "free money."
    >
    > He had better hope inflation will save him. So far he's had to "write
    > down" his balance sheet considerably. That counts as "taking a bath."
    Reply | Link to Comment
  •  
    Nov 22 06:39 PM
    Warren Buffet has earned the benefit of the doubt. Inflation is his best friend. At the pace that money is being created serious inflation is on the horizon. The use of the money for 10 years is also a huge benefit. If you look at his track record and his return on money he invests over the last 20 years Berkshire should continue to deliver the same results over the next ten years as it did the last twenty.

    How many of you were calling Buffet stupid because he did not invest in any of the internet craze. You were the idiots as his model proved correct over the long run.


    On Nov 22 12:28 PM najdorf wrote:

    > Comparing stock levels in the period from now to 2020+ to stock prices
    > in the period from 1929 to 1954 is one of the most insane hobby horses
    > to ride around on. 1929-1954 included the worst depression in our
    > history and the worst war in our history. It also was a time when
    > companies paid much higher dividends and had lower levels of retained
    > earnings/buybacks, lowering stock prices. American had little or
    > no inflation until after WWII, also holding down stock prices (you
    > might have noticed that this has changed). Finally, 1929 was like
    > 1999-2000 for bubbleish peak prices. We've gone sideways for 10 years,
    > which means that if anything we should be comparing today to 1939.
    >
    >
    > If stocks aren't higher when BRK's puts expire, what alternate strategies
    > would you retrospectively recommend? Investing in Treasuries at negative
    > real yields and widening credit risk? Buying stocks that go nowhere?
    > Sitting in cash and continuing to pray BRK doesn't get hit with any
    > big insurance claims? A company like BRK has to take stock market
    > risk - that's the whole point of the company! Out of all stock market
    > risks available, the one Buffett chose by selling these puts was
    > a pretty good one. Accounting earnings don't matter to this company,
    > although if they do take the big cash hit all those years down the
    > line it might kill them. It's a cost of doing business - if it wasn't
    > difficult and risky everyone would be doing it.
    Reply | Link to Comment
  •  
    Nov 22 08:20 PM
    Buffett is not perfect but he is a genus.
    Reply | Link to Comment
  •  
    Nov 23 10:00 AM
    Beware the Wall Street traders and investors who believe their own press releases. People tend to forget that Berkshire has rushed in to insure assets and debt which, in the past, they would have shied away from. To believe that Buffett has a better understanding of these credit derivatives than Bear Stearns or Lehman did is to simply throw out the greater fool theory on the basis that Buffett is not, obviously, a fool.

    But what if he is? He's got an enormous stake in Moody's, which has just cratered, and his General Re's dealings with AIG has potentially put him on the hook for billions more. Now he's been pushing BRK into the municipal finance insurance market, on the cusp of a wave of bankruptcies caused by--at the very least--a severe recession.

    Were BRK a closed-end fund, it would be trading at a hefty premium. And premiums never last.
    Reply | Link to Comment
  •  
    Nov 23 01:52 PM
    Says the author: "Either the U.S. is headed for a decade-long depression or we these are going to pay off well."

    Sez Google: 27 Oct 2008 ... Tokyo's Nikkei 225 index closed down 6.4 percent to 7162.90 - ... to its lowest level in 26 years.
    Reply | Link to Comment
  •  
    Nov 23 03:01 PM
    My word, is everybody insane?

    The buyer of the index puts (the party/parties who paid the $4.5B to Buffett) did so for the simple reason that they needed to maintain net worth covenants during this downturn. It's all a big accounting fiction and it's a close to a sure thing win for Berkshire as you can get.

    As the market tanks, the puts rise in value. This allows the seller to artificially mark up his books (by some accounts, $18B so far).

    Now, is the seller really ahead by $18B...? No!

    And why not? Because those puts cannot be exercized until way in the future. Any gain that's there is not currently realizable.

    So why do it?

    The seller gets a mechanism by which his books can show a gain and thereby not show a net drop off in total worth as the market crashes. And Buffett gets $4.5B with which he can buy preferred securities that yield in excess of the return he needs to pay the puts - if he must pay the full amount.

    Do the math - the compounding that Buffett has already locked in with the GS and GE preferreds puts him 100% safe regarding his future obligations on these puts.

    So who bought the puts? My guess is a wealthy family that has a large controlling interest in a major corporation. Likely, there are some substantial borrowings which have net worth covenants and therefore, these puts will let them ride things out safely because these rise when the market fallls.

    In the end, the buyer will keep control of their current status and it will have cost Buffett nothing for letting them lean on him for an extended period of time.

    Anyone who thinks Berkshire is losing out here is stupid.
    Reply | Link to Comment
  •  
    Nov 23 03:06 PM


    Oops!

    Transposed seller/buyer in a few places...


    On Nov 23 03:01 PM sr9web wrote:

    > My word, is everybody insane?
    >
    > The buyer of the index puts (the party/parties who paid the $4.5B
    > to Buffett) did so for the simple reason that they needed to maintain
    > net worth covenants during this downturn. It's all a big accounting
    > fiction and it's a close to a sure thing win for Berkshire as you
    > can get.
    >
    > As the market tanks, the puts rise in value. This allows the seller
    > to artificially mark up his books (by some accounts, $18B so far).
    >
    >
    > Now, is the seller really ahead by $18B...? No!
    >
    > And why not? Because those puts cannot be exercized until way in
    > the future. Any gain that's there is not currently realizable. <br/>
    >
    > So why do it?
    >
    > The seller gets a mechanism by which his books can show a gain and
    > thereby not show a net drop off in total worth as the market crashes.
    > And Buffett gets $4.5B with which he can buy preferred securities
    > that yield in excess of the return he needs to pay the puts - if
    > he must pay the full amount.
    >
    > Do the math - the compounding that Buffett has already locked in
    > with the GS and GE preferreds puts him 100% safe regarding his future
    > obligations on these puts.
    >
    > So who bought the puts? My guess is a wealthy family that has a large
    > controlling interest in a major corporation. Likely, there are some
    > substantial borrowings which have net worth covenants and therefore,
    > these puts will let them ride things out safely because these rise
    > when the market fallls.
    >
    > In the end, the buyer will keep control of their current status and
    > it will have cost Buffett nothing for letting them lean on him for
    > an extended period of time.
    >
    > Anyone who thinks Berkshire is losing out here is stupid.
    Reply | Link to Comment
  •  
    Nov 23 03:13 PM
    Comparing US to Japan is silly. The productivity gap between US and Japanese workers are huge. US still has large oil reserve (obviously, environmental consideration will have to go if things get REALLY bad) and has corporation that are far more efficient than Japanese (Japan has a few world class automakers and electronics firm, full stop; US has Mcdonalds, Visa, Mastercard, GE, Microsoft, Intel, Cisco, Google, 3M, Caterpillar, Boeing) etc.

    World economic forum (www.weforum.org/en/ini...) continue to ranked US as the most competitive country on the planet (a role which it held since like forever).

    Despite the huge problem, I won't bet on US being poorer 10 years from now..
    Reply | Link to Comment