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Is Berkshire in Trouble?

Published on November 20, 2008

Is Berkshire in Trouble?

November 20, 2008

This 2 part series will cover recent market developments about Berkshire Hathaway, points to a strategy on how you may benefit more on the same trades he did recently and an option trading strategy that probably Berkshire uses for maximizing it returns on the underlying they find worth investing. Don’t forget to read the big picture of US stock markets. Markets are behaving pretty much that way. I am opening December portfolios for OPNewsletter, to join, pls click here.

Before I proceed, I must mention that I admire Mr Buffett’s skills. I got an opportunity to meet-up face to face with him in 2005 and it was one of the finest moments of my life to first hand hear the living legend. Listening and questioning him propelled my learning about his style way more than any book did. I, in no way can doubt his selection or will know in full his style of investing. Beyond classic investing theory, his intuition is par excellence. So below post is a mere attempt to interpret in my way. Pls do your own due diligence before making any decision based on info presented here.

According to Forbes, The credit default swap market says the Oracle of Omaha is headed for trouble. The credit default swap market thinks so. Spreads on insurance against a debt default by Warren Buffett’s triple-A-rated Berkshire Hathaway are trading about on par with that of the embattled General Electric and worse than Goldman Sachs and Citigroup. Per same article, “Credit default swaps on Berkshire traded at 440 Wednesday, according to Phoenix Partners Group.

That means it cost $440,000 a year to insure $10 million of Berkshire bonds. Last week, the spread was 250. Insurance on debt of General Electric–which arguably has bigger issues than Berkshire Hathaway, mostly because of its giant finance division–was trading at 445 by comparison, according to Phoenix Partners. Insurance contracts on Citi and Goldman traded at spreads of 350 and 330, respectively. That implies greater fear of a default by Berkshire than by companies that have been hammered by tens of billions in write-downs, rising credit costs, and bleak near-term earnings prospects”. Not only that, shares of Berkshire Hathaway traded down 12% Wednesday (making it almost 40% decline year-to-date).

Here is a brief recap of Mr Buffett’s purchases in past two months, spent $5 billion of Berkshire’s cash for a stake in Goldman Sachs Group Inc. (GS), and another $5 billion in preferred shares of General Electric Co (GE) He also agreed in July to lend $3 billion to Dow Chemical Co  (DOW). to help fund that firm’s takeover of Rohm & Haas Co., and committed $6.5 billion in April to help Mars Inc. buy chewing gum maker Wm. Wrigley Jr. Co. Berkshire’s MidAmerican Energy Holdings Co. struck a deal in September to pay $4.7 billion for Constellation Energy Group Inc (CEG). Shares of Goldman have slumped over 50% since the end of September and closed at $55.18 yesterday. Shares of GE are down over 40% in the same period and closed at $14.45 yesterday. So there are billions of unrealized paper losses from the two stalwarts.

Berkshire’s profits fell 77% in the third quarter, to $1 billion, on catastrophe insurance claims and weak equity markets. Its exposure to derivatives, for which it had to take a $1.26 billion pre-tax loss. A big bet on four major stock indexes may be behind the wacky trading in the credit default swap market. Berkshire sold options contracts based on the value of four equity market indexes over the next decade. If the indexes–including the Standard & Poor’s 500–are below the level they were at when the contracts were written, Berkshire will have to pay out billions.

Albeit, remember this story when Bershire was betting on global stock market by using derivatives. Berkshire sold a form of insurance to buyers who wanted protection from a drop in “four major equity indexes” over the next 15 to 20 years, according to a Securities and Exchange Commission filing. Instead of buying the individual shares, Buffett is wagering the indexes, three of which are outside the U.S., won’t tumble and force Omaha-based Berkshire to pay a claim.

The strategy was to invest premium received upfront. Mr. Buffett has said the derivative contracts expire between 2019 and 2027, and that he expects them to be profitable. In the interim, Berkshire is able to invest the upfront premiums it received by entering into the contracts. But the contracts aren’t set to expire until 2019. Down in the current environment, they could bounce back by then, and Berkshire would be on the hook for nothing.

How can you participate in the same deals than Mr Buffett did but better than him, assuming you think his chosen underlying are brilliant. According to this article published on Wall Street Journal, James shares a combo approach of Bonds + Options. Note that these Goldman bonds are senior to both Mr. Buffett’s preferred stock and the government’s, which means bond interest and principal gets paid before either Mr. Buffett or the Treasury. And as an option trader, you also have flexibility to customize your strategies to hedge your positions.

But underlying premise is that you know and very well understand what you are getting into.

In part-2 I shall be discussinig how Berkshire, probably, uses a option trading strategy to maximize returns on underlying it thinks arre worth investing.

Profitable trading, OP

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