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Wednesday 25 February 2009
Is Buffett getting margin calls?
Rumours are popping up on the Street that Warren Buffett may have received margin calls related to derivative/option investments. Yes, these are the same type of investment that Buffett has termed, “financial weapons of mass destruction.”
Rumours are popping up on the Street that Warren Buffett may have received margin calls related to derivative/option investments. Yes, these are the same type of investment that Buffett has termed, “financial weapons of mass destruction.”
As crazy as this may sound, there is obviously something going badly wrong since Buffett’s Berkshire Hathaway (BRK.A) is down over 20% in 2009 and many of the individual positions within the portfolio have been outright devastated.
To add insult to injury, Buffett has recently made many ill-timed investments that are wreaking havoc within his portfolio, which is down a whopping 45% over the past 12 months. Back in May 2008, Buffett was convinced that the credit crisis was coming to an end when he proclaimed to the world on Bloomberg Television, “The worst of the crisis in Wall Street is over.” Unfortunately, he put his money where his mouth was and decided to add positions to the portfolio and several have dropped more than 50% since. That isn’t the only problem.
Over the past few months, it has been painful to watch the publicly traded equity positions within Berkshire crumble. Now it appears that Buffett is faced with rumours circulating that Put Options he sold on broad market indices, such as the S&P 500, are increasing in value at an alarming rate. Since he is the seller of the options, there may be a requirement for additional collateral/funds to offset the losses as markets continue to decline.
Since a put option gives an investor the right to sell a particular security at an agreed upon price until a predetermined date in the future, Buffett’s investment is similar to a leveraged bull strategy. Translated, this means that he believes the market will increase over time. In fact, the put option sold on various market indices were so far out-of-the-money when the transaction was completed, it was hard to believe that there was a chance for the option to be exercised. That is not the case any longer.
In just the past week we have seen the S&P 500 fall by more than 10%. That does not bode well for a bullish option position. Realize that with a leveraged position, if it declines in value beyond the amount of initial cash up-front, more monies (aka margin calls) may be required in order to continue holding the position. If these margin calls have not been met, then the position can be liquidated.
Will that happen to Berkshire? Probably not as they still have a significant amount of cash available. But it is interesting to look at the most recent quarterly report from Berkshire and find management explaining how volatility may affect the pricing of their derivative holdings:
In addition, the Black-Scholes calculations incorporate volatility estimates which are generally not observable. At September 30, 2008, the estimated fair value of these contracts was $6,725 million and the weighted average volatility was approximately 22%.The impact on fair value from changes to volatility is summarized below. The values of contracts in an actual exchange are affected by market conditions and perceptions of the buyers and sellers. Actual values in an exchange may differ significantly from the values produced by any mathematical model. Dollars are in millions.
As illustrated above, volatility plays an important role in calculating values of options and other derivative securities. Back in September 2008, the CBOE Volatility Index ($VIX) was hovering around 22. With every 2-percentage point increase, the value of the Berkshire contracts increase by approximately 18%. As the $VIX is now approaching 49, Mr. Buffett must be concerned with the potential hit to earnings and the need to add funds to back the financial requirements of the put options.
These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at the expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make payment only if the index in question is quoted at a level below that existing on the day the put was written? I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15-or-20 year period? in all cases we hold the money, which means we have no counterparty risk.
To Be Downgraded?
The interesting take away from the recent quarterly report is to see all of the positions that were sold. Perhaps many of these positions were cashed out in order to bring up cash levels to back the options exposure and provide a cushion for the portfolio. Now we need to looking at the impact on earnings, as there is the potential for a $4-5 billion write-down for the quarter related to derivatives. This could compress ratios and cause a further decline in the share price for Berkshire Hathaway. In fact, it is possible that this could be the first quarter of negative earnings growth for Mr. Buffett. All in all, that is depressing.
If you look at past times when he's gone crazy buying, many of his positions dropped 40-50%. Standard operating procedure for warren. Anyways other than BNI he hasnt really gone crazy buying yet-he's been loaning money at extremely high interest rates-selling the buffett aproval stamp. The market has to drop another 30% to get to the level that he usually goes crazy buying. His partner Mungers Wesco is still all cash--until he pulls the trigger you know we arent even close to the bottom of this market.
2 comments:
Is Buffett getting margin calls?
Andrew Horowitz
24 February 2009
Rumours are popping up on the Street that Warren Buffett may have received margin calls related to derivative/option investments. Yes, these are the same type of investment that Buffett has termed, “financial weapons of mass destruction.”
As crazy as this may sound, there is obviously something going badly wrong since Buffett’s Berkshire Hathaway (BRK.A) is down over 20% in 2009 and many of the individual positions within the portfolio have been outright devastated.
To add insult to injury, Buffett has recently made many ill-timed investments that are wreaking havoc within his portfolio, which is down a whopping 45% over the past 12 months. Back in May 2008, Buffett was convinced that the credit crisis was coming to an end when he proclaimed to the world on Bloomberg Television, “The worst of the crisis in Wall Street is over.” Unfortunately, he put his money where his mouth was and decided to add positions to the portfolio and several have dropped more than 50% since. That isn’t the only problem.
Over the past few months, it has been painful to watch the publicly traded equity positions within Berkshire crumble. Now it appears that Buffett is faced with rumours circulating that Put Options he sold on broad market indices, such as the S&P 500, are increasing in value at an alarming rate. Since he is the seller of the options, there may be a requirement for additional collateral/funds to offset the losses as markets continue to decline.
Since a put option gives an investor the right to sell a particular security at an agreed upon price until a predetermined date in the future, Buffett’s investment is similar to a leveraged bull strategy. Translated, this means that he believes the market will increase over time. In fact, the put option sold on various market indices were so far out-of-the-money when the transaction was completed, it was hard to believe that there was a chance for the option to be exercised. That is not the case any longer.
In just the past week we have seen the S&P 500 fall by more than 10%. That does not bode well for a bullish option position. Realize that with a leveraged position, if it declines in value beyond the amount of initial cash up-front, more monies (aka margin calls) may be required in order to continue holding the position. If these margin calls have not been met, then the position can be liquidated.
Will that happen to Berkshire? Probably not as they still have a significant amount of cash available. But it is interesting to look at the most recent quarterly report from Berkshire and find management explaining how volatility may affect the pricing of their derivative holdings:
In addition, the Black-Scholes calculations incorporate volatility estimates which are generally not observable. At September 30, 2008, the estimated fair value of these contracts was $6,725 million and the weighted average volatility was approximately 22%.The impact on fair value from changes to volatility is summarized below. The values of contracts in an actual exchange are affected by market conditions and perceptions of the buyers and sellers. Actual values in an exchange may differ significantly from the values produced by any mathematical model. Dollars are in millions.
Hypothetical change in volatility (percentage points)
Hypothetical fair value
Increase 2 percentage points
$7,231
Increase 4 percentage points
7,733
Decrease 2 percentage points
6,217
Decrease 4 percentage points
5,709
As illustrated above, volatility plays an important role in calculating values of options and other derivative securities. Back in September 2008, the CBOE Volatility Index ($VIX) was hovering around 22. With every 2-percentage point increase, the value of the Berkshire contracts increase by approximately 18%. As the $VIX is now approaching 49, Mr. Buffett must be concerned with the potential hit to earnings and the need to add funds to back the financial requirements of the put options.
These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at the expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make payment only if the index in question is quoted at a level below that existing on the day the put was written? I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15-or-20 year period? in all cases we hold the money, which means we have no counterparty risk.
To Be Downgraded?
The interesting take away from the recent quarterly report is to see all of the positions that were sold. Perhaps many of these positions were cashed out in order to bring up cash levels to back the options exposure and provide a cushion for the portfolio. Now we need to looking at the impact on earnings, as there is the potential for a $4-5 billion write-down for the quarter related to derivatives. This could compress ratios and cause a further decline in the share price for Berkshire Hathaway. In fact, it is possible that this could be the first quarter of negative earnings growth for Mr. Buffett. All in all, that is depressing.
If you look at past times when he's gone crazy buying, many of his positions dropped 40-50%. Standard operating procedure for warren. Anyways other than BNI he hasnt really gone crazy buying yet-he's been loaning money at extremely high interest rates-selling the buffett aproval stamp. The market has to drop another 30% to get to the level that he usually goes crazy buying. His partner Mungers Wesco is still all cash--until he pulls the trigger you know we arent even close to the bottom of this market.
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