Berkshire Hathaway Inc. BRK-A
November 19, 2008 - 3:40pm EST by
reg015
2008 2009
Price: 84,600.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 133,830 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

BRK AAA 5 year CDS is running at around 400 bps, and 10 years at slightly over 400.

This is more than four times that of rival insurer Travelers Co.  At those levels, this is more typical of companies rated by Moody’s as Baa3--one notch above junk.  The prices have risen on concerns that BRK could lose on a $37 billion option exposure.

But what is their exposure?  From their last 10K:

  1. BRK sold protection on high yield indices, with expiration from 2009 to 2013.  They received $3.2 billion in premiums in 2007, and paid $472 million in losses.  10K has their expected worst case loss at an additional $4.7 billion.
  2. BRK sold naked European puts on S&P and 3 foreign indices which expire between 2019 and 2027.  This is definitely a bad trade right now, and hence the bulk of the worry about option exposure.  But these are European options, and cannot be exercised by their counterparty until the expiry.  So while  accounting for options does hit their income statement, it has no effect on BRK’s cashflow--if they are going to take a hit on these options, it’s not at least for another 10 years.  Meanwhile, BRK gets $4.5 billion per annum in premium which they can invest.

So the only possibility of a hit on their cash is the protection BRK sold on HY indices.  Let’s assume that their worst case default scenario is true, hell, double that, we’re still talking about less than $10 billion.  BRK’s quick ratio is 1.59 as of September 30, and their cash equiv + current receivables - current liabilities gives you a $17 billion cushion.  BRK is not AIG; BRK actually has enough free cash to pay for any possible losses from the protection they sold.

Given the above, is it really conceivable that BRK is going to default within 5 years?  I’m not talking about having the possibility of BRK taking an earnings hit, but rather default.
 

Recommendation: sell protection with 5 year BRK CDSes.  Collect premium.  You'd never have to pay out.

Possible upside: 4% premium ($400K per annum on $10 million notional) on a PAUG instrument that you can easily lever.  Also, the spreads may narrow to a more reasonable 200 bps or so in short order as people realize that at least the 5 year spread is way too wide (for an $800K gain if you want to novate the contract to someone else).

Possible downside: irrationality temporarily persists and BRK 5 year protection widens another 200 bps, giving you about an $800K mark to market loss.  You may have to post additional collateral, depending on your credit rating in addition to the mark-to-market hit.  However, if you do hold to maturity, it is pretty much free money.

Catalyst

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    Description

    BRK AAA 5 year CDS is running at around 400 bps, and 10 years at slightly over 400.

    This is more than four times that of rival insurer Travelers Co.  At those levels, this is more typical of companies rated by Moody’s as Baa3--one notch above junk.  The prices have risen on concerns that BRK could lose on a $37 billion option exposure.

    But what is their exposure?  From their last 10K:

    1. BRK sold protection on high yield indices, with expiration from 2009 to 2013.  They received $3.2 billion in premiums in 2007, and paid $472 million in losses.  10K has their expected worst case loss at an additional $4.7 billion.
    2. BRK sold naked European puts on S&P and 3 foreign indices which expire between 2019 and 2027.  This is definitely a bad trade right now, and hence the bulk of the worry about option exposure.  But these are European options, and cannot be exercised by their counterparty until the expiry.  So while  accounting for options does hit their income statement, it has no effect on BRK’s cashflow--if they are going to take a hit on these options, it’s not at least for another 10 years.  Meanwhile, BRK gets $4.5 billion per annum in premium which they can invest.

    So the only possibility of a hit on their cash is the protection BRK sold on HY indices.  Let’s assume that their worst case default scenario is true, hell, double that, we’re still talking about less than $10 billion.  BRK’s quick ratio is 1.59 as of September 30, and their cash equiv + current receivables - current liabilities gives you a $17 billion cushion.  BRK is not AIG; BRK actually has enough free cash to pay for any possible losses from the protection they sold.

    Given the above, is it really conceivable that BRK is going to default within 5 years?  I’m not talking about having the possibility of BRK taking an earnings hit, but rather default.
     

    Recommendation: sell protection with 5 year BRK CDSes.  Collect premium.  You'd never have to pay out.

    Possible upside: 4% premium ($400K per annum on $10 million notional) on a PAUG instrument that you can easily lever.  Also, the spreads may narrow to a more reasonable 200 bps or so in short order as people realize that at least the 5 year spread is way too wide (for an $800K gain if you want to novate the contract to someone else).

    Possible downside: irrationality temporarily persists and BRK 5 year protection widens another 200 bps, giving you about an $800K mark to market loss.  You may have to post additional collateral, depending on your credit rating in addition to the mark-to-market hit.  However, if you do hold to maturity, it is pretty much free money.

    Catalyst

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    Messages


    SubjectROIC
    Entry11/19/2008 03:57 PM
    Memberdoobadoo802
    What is the likely capital requirement for this position? I will accept your credit analysis, but how much risk capital needs to be tied up to earn this number? In case you didn't notice, there is little yield in short term treasuries, so 400k is all you'll get on the collateral. What kind of roic does this compute to? What are the odds that cds become so toxic that margin can go to 100%? Then you only earn 4% on your money. That may be a wild scenario, but these are indeed wild times. I'm just trying to see if we're missing something here...

    Subject$4.5b premium
    Entry11/19/2008 04:26 PM
    Memberfinn520
    Note on details, I believe BRK got the $4.5b premium one time up front, not "$4.5b per annum", which would be a sweet deal, indeed. Interesting to see what Buffett does if Berkshire stock keeps falling like this. Is there any business risk at all to Berkshire from a falling stock price? If no, then a buyback would have to be weighed against all other uses of the capital, and I based on Buffett's track record, I would imagine he would invest elsewhere. Fascinating to watch.

    SubjectBetter off buying the stock
    Entry11/19/2008 05:05 PM
    Memberalgonquin222
    I think you are better off buying the equity. You never have to post collateral and the upside, if the puts end up out of the money, is probably a doubling of your money from these levels.

    SubjectRE: premium on index puts
    Entry11/19/2008 09:05 PM
    Memberreg015
    You're right - the naked European puts are a one-time premium of $4.8 B. My fingers ran faster than my head - I kept typing per annum w/r/t CDS payments... As far as I know, the puts are on equity indices. BRK isn't doing anything fancy like wrapping the senior tranche of someone's CDO. It's a straight European put with an exercise date 10 years or more out in the future. If BRK's counterparties (and we don't know who they are) are worried about BRK not being able to pay more than 10 years from now, I would posit that perhaps the 10 year or longer CDS would be a better hedge, as the duration would be better matched.

    SubjectRE: $4.5b premium
    Entry11/19/2008 09:28 PM
    Memberreg015
    Well, there is a VERY REAL RISK - mark-to-market losses, and potential need to post collateral. If you can stomach the vol, and even if you have to post 100% of the notional in collateral (pretty much impossible), you'd still net 4% per annum. Multiply that by the amount of leverage you're willing to use. Remember, this is pay as you go - you post no money up front - during the 5 years you are collecting premiums, you'd only make a payment if and only if the underlier, presumably the BRK senior bonds, actually defaults. Any collateral you post, you will receive back at the end of year 5. Furthermore, if you have possible offsetting positions -- e.g., you have already bought protection on monolines or what have you, then your prime broker may not ask you for additional collateral (all that can be negotiated). The liquidity event that everyone's afraid of--the exercise of these European puts, is more than 10 years out, and it is highly unlikely that BRK would go bust within 5 years. The biggest risk is that someone downgrades BRK, then BRK has to post additional collateral. But I posit that at least as of 9/30, BRK has more than sufficient free cash to be able to post any necessary collateral. BRK hasn't leveraged themselves to the hilt selling protection on tranches of CDOs which could never actually be paid. The real risk one has to consider is -- if the spreads widen, can you eat the mark-to-market loss and hold to maturity? If you can hold for 5 years, and agree that BRK will not default on their senior notes within 5 years, then this is a way of getting good yield in this environment.

    SubjectRE: downgrade
    Entry11/24/2008 12:08 PM
    Memberdoggy835
    Berkshire has indicated they have minimal collateral requirements across their book and effectively none on the European puts.

    One rumor is GS bought these puts from BRK to hedge deals with end customers. Those end customers now want GS to post collateral. So GS hedged their loss exposure but not their collateral exposure, and now they're scrambling. I give this rumor no credence, but it illustrates the belief that BRK need not post collateral even if downgraded.
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