A market economy creates some lopsided payoffs to participants. The right endowment of vocal chords, anatomical structure, physical strength, or mental powers can produce enormous piles of claim checks (stocks, bonds, and other forms of capital) on future national output. Proper selection of ancestors similarly can result in lifetime supplies of such tickets upon birth. If zero real investment returns diverted a bit greater portion of the national output from such stockholders to equally worthy and hardworking citizens lacking jackpot-producing talents, it would seem unlikely to pose such an insult to an equitable world as to risk Divine Intervention.
How Inflation Swindles the Equity Investor by Warren E. Buffett, Fortune May 1977
As the current CDO/MBS meltdown manifests itself in varying ways throughout our financial system we’ve seen Mr Buffett’s name with increasing regularity in the financial press. His recent 2008 shareholder letter was widely cited early last week in the press for instance, especially the paragraph that attempts to put current events in a historical perspective. I was drawn to the paragraph two above that one:
This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation. Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly.
I immediately wondered what he meant by ‘They”. “They won’t leave willingly”. And is this the same “they” that brought us this disaster? Did anyone at CNBC, the Wall Street Journal or the New York Times read Buffett’s letter with a critical eye? I’ll warn our readers now this will be a long post by necessity.
First we’ll start with a blog entry from Seeking Alpha that appeared yesterday on our Hartford Bankruptcy Watch RSS feed. The entry and commentary, which we will explore in some detail, is stunning in both detail and human psychology. I don’t buy the author’s conclusions as a closer look at his data suggests something entirely different but let’s start with the numbers which are indisputable:
Markets at times are rational, efficient, information-processing mechanisms which correctly price asset markets.
And at other times, the market is an idiot.
This struck me – as it does every day looking at my screens – reading this article from Bloomberg.
Warren Buffett’s Berkshire Hathaway Inc. and Jeffrey Immelt’s General Electric Co. are being battered in the market for credit-default swaps, treating both AAA companies like junk.
Let’s put aside GE for a moment, because I think there is some legitimate debate regarding this company. But Berkshire Hathaway a junk credit?
Investors are paying as much for contracts that protect against a default on the bonds of Omaha, Nebraska-based Berkshire, which has $25.5 billion in cash, as for KB Home, the homebuilder that lost money for seven consecutive quarters. The cost of credit-default swaps on the finance arm of GE and its $45 billion in cash is about the same as for building materials- maker Louisiana-Pacific Corp., which posted nine straight quarterly losses. …
Swaps on Berkshire have soared 2.26 percentage points the past two weeks to 5.35 percent a year, CMA data show. That compares with 4.9 percent annually for Los Angeles-based KB Home.
Berkshire and KB Home (KBH) priced the same in the credit default swap (CDS) market?
Yep that is right, in a marketplace of knowledgeable and willing buyers and sellers the market rates the creditworthiness of Berkshire Hathaway about the same as KB Home as the Bloomberg story continues:
Swaps on Berkshire have climbed 2.09 percentage points the past three weeks to 5 percent a year, CMA data show. Contracts on Los Angeles-based KB Home trade at the same level.
Buffett said in his annual letter to shareholders Feb. 28 that companies such as his that haven’t taken government bailouts or don’t have access to state funding are effectively being penalized by markets. More than 500 banks, insurers and credit- card companies applied for capital from the Troubled Asset Relief Program and the government has distributed almost $300 billion.
“Funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be,” he wrote. “Government is determining the ‘haves’ and ‘have-nots’.”
So the pricing trend on BRK credit default swaps is very recent. While the author of the Seeking Alpha piece runs off to mine solace from Mr Buffett’s shareholder letter what have we found recently at Slabbed justifies the recent price swing in BRK swaps. First off we need to start with Swiss Re, a company that Berkshire Hathaway has a substantial stake in an entry we published last month, roughly 3 weeks ago in fact:
Moody’s Investors Service in London said today it has downgraded the loss-battered Swiss Reinsurance Company and its subsidiaries yet another notch.
The rating service–which on Feb. 6 had dropped the company from “Aa2” to “Aa3” (“Excellent”)–said it has now cut the firm’s insurance financial strength and senior debt ratings from “Aa3” to “A1” (“Good”) and assigned a negative outlook. Short-term ratings of “Prime-1” were affirmed.
Swiss Re’s rating problems began with the firm’s surprise revelation on Feb. 6 that it might have losses for 2008 of up to CHF 1 billion ($860 million, at current exchange rates), and that it had made arrangements to secure $2.6 billion in capital from Berkshire Hathaway and would cut back its dividend. The loss figure was changed to CHF $864 million ($736.3 million) last Friday.
Before that, on Feb. 12, Swiss Re replaced its chief executive officer, Jacques Aigrain, with Deputy Chief Executive Officer and Chief Operating Officer Stefan Lippe.
Moody’s said its rating downgrade is prompted by Swiss Re’s “weakening profitability, capital adequacy, and financial flexibility metrics.”
Going forward, Moody’s said it expects the Group’s core reinsurance activities to continue to perform well, but sees the potential in the short-term for overall profitability to be suppressed by further mark-to-market losses.
This commenter to the Seeking Alpha entry well summed up why the luster has worn off BRK:
It was cheaper to insure $1,000,000 of debt issued by the Republic of Vietnam than insuring the same amount of money from BH. The article misses the fact that the fundamental engine of the company is the insurance “float” or premiums they’ve received from other people’s policies, be they cars (GEICO) reinsurance (General Re) or a regular insurer that Berkshire Hathaway controls – it’s 58 billion dollars. BRK shrank by 11.8 billion dollars. I feel bad the author bought shares in BRK now that they are at $70,000 but they have farther to fall. The insurer units are made up with corporate bonds and as asset prices have fallen, so do the bonds. If you thought and imagined how much money the Berkshire Hathway insurers lost on the Big 3 automakers, or bank bonds, you name it, it lost value and defaults are up, The float dries up and the boat sinks. You think See’s Candies or that 20% in Moody’s is worth anything? All the non-insurance related companies provide a mere fraction of the insurance companies and they didn’t do great either. It’s all in the 2008 end of year statement – they are not positioned well for any sustained downturn, and this is coming from someone who has great respect for a man who built an impressive company but all plaudits aside, market participants take notice when your total net asset value of securities equals your total net asset cost of securities. They hoarded all that cash for years and jumped the gun and the spread is against them and the market is accurately pricing it.
And finally what of this nonsense that Berkshire Hathaway is not benefiting from the massive amounts of money the US Treasury is throwing around the financial system these days? Perhaps not directly but certainly indirectly as we skip back to the Bloomberg story:
Berkshire in 2008 started writing credit-default swaps on individual companies, with contracts guaranteeing $4 billion of debt from 42 borrowers, Buffett said in the letter. The company is unlikely to expand the position because “most buyers of this protection now insist that the seller post collateral, and we will not enter into such an arrangement,” he said.
Buffett has struck deals with firms that Berkshire hasn’t identified to protect them against declines in four equity indexes and guarantees on indexes of non-investment grade debtors that require the company to pay out when there’s a default.
The firms that bought the derivatives from Berkshire may now be buying credit swaps on the company to ensure they get paid, Jeff Matthews, author of “Pilgrimage to Warren Buffett’s Omaha” and founder of hedge fund Ram Partners LP, said earlier this week.
There is no telling how much of that portfolio is still good because of TARP but we do know courtesy of the Wall Street Journal another of Buffett’s recent investments, the one in Goldman Sachs has benefited greatly from the program:
The beneficiaries of the government’s bailout of American International Group Inc. include at least two dozen U.S. and foreign financial institutions that have been paid roughly $50 billion since the Federal Reserve first extended aid to the insurance giant.
Among those institutions are Goldman Sachs Group Inc. and Germany’s Deutsche Bank AG, each of which received roughly $6 billion in payments between mid-September and December 2008, according to a confidential document and people familiar with the matter.
In the end, with the tangled web of guarantees and cross guarantees, partial ownership stakes and the like the market still does not know the extent of the financial damage wrought by subprime speculation as evidenced by the growing amount of taxpayer money AIG consumes daily. Does that fact more than explain BRK’s CDS pricing than simply chalking the recent trend to investor irrationality, which is frankly simplistic wishful thinking? Warren Buffett is a man just like the rest of us, and just as fallible despite the hype. Can Berkshire Hathaway go bankrupt? You bet they can and the market understands that fact.
In the end traders attempting to force long positions with these financial services issues are, in stock parlance, trying to “catch a falling knife” which is never a good idea: