Berkshire Hathaway Inc. BRK-A
November 19, 2008 - 3:40pm EST by
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

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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.


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