Thursday, August 5, 2010

"Buffett Gets In A Bind Over Options" (BRK.B; BRK.A)

The nemesis, regulatory risk.
From Reuters via the New York Times:

One small change in the law could make Warren Buffett's billion dollar bet on global equity markets look less like a winner.

Buffett's Berkshire Hathaway has sold billions in options since 2004, betting that stock markets would rise over 15 or even 20 years.
But a new law requiring most derivatives users to post collateral on trades could diminish potential gains to the point where Buffett could lose interest in keeping his bet. Options prices have been rising amid concern that Buffett might buy back the options he sold, traders said.

Even if rulemakers water down the financial reform law, banks may push Berkshire Hathaway to post collateral now that it no longer carries pristine triple-A credit ratings.
Berkshire Hathaway has prided itself on not putting up collateral on most of its options portfolio, even in 2008 when option values rose, triggering more than $5 billion in paper losses on the contracts he had sold.
Rising options values are likely to have triggered paper losses for Berkshire Hathaway in the second quarter as well. The insurer reports its results on Friday.

Buffett has repeatedly said he is not bothered by those paper losses, but posting collateral could be a problem. When Berkshire Hathaway sold the options, it received billions of dollars in upfront cash premiums. It can use that money as it pleases. If it had to put up collateral, it would effectively get a much lower return on that trade.

"He doesn't want capital tied up in a low-return venture, which is probably what he would see it to be if he had to post full collateral," said Philip Guziec, Morningstar derivatives strategist in Chicago.
In the worst-case scenario, if markets tank and Buffett has to post collateral, he could face tens of billions of dollars if the underlying stock indexes went to zero.
That seems unlikely, but other insurance companies have been walloped by guaranteeing risks in financial markets that seemed remote.

In December 2007, American International Group executives hosted a lengthy conference call in which they repeatedly told investors that they were unlikely to suffer economic losses from credit default protection it wrote on repackaged mortgage securities.

After $182 billion of taxpayer bailouts for the insurer, it is clear that the executives were wrong.
At the end of last year, Omaha, Nebraska-based Berkshire had about $63.1 billion of derivatives exposure. Roughly 60 percent, or $38 billion, was from equity index options.
Across its equity and credit derivatives, the company said it was required to post just $35 million in collateral. Berkshire Hathaway had cash of $28 billion and total assets of $297.1 billion at the end of 2009.

Buffett famously commented in a letter to shareholders in February, 2003, that derivatives can be "financial weapons of mass destruction."
Yet while the 79-year-old has always defended Berkshire's options plays to shareholders, most of these contracts were entered before lawmakers began discussing financial reform.
The financial crisis highlighted the risks of the $615-trillion over-the-counter derivatives market and it became one of the focuses of the reform.

Over-the-counter derivatives, which are contracts that are traded privately rather than on an exchange, created a web of dependence among banks and their customers, meaning that the failure of any one dealer could wreak havoc on the system.

That some players did not have to post collateral on their trades meant that a single customer's failure could cause major repercussions.

The Dodd-Frank Act signed in July forces most derivatives users to post collateral, a provision that Berkshire Hathaway lobbied against. Lawmakers agreed to exclude some users of derivatives, those deemed "commercial end users," from the requirements [ID:nN01138000].

"It's pretty clear (Warren Buffett is) not a commercial end user," said Sherri Venokur, a derivatives attorney in New York, adding that lawmakers intended the exemption for power companies and airlines, among others....MORE