On September 23,2008,Warren Buffett’s (WB) Investment Behemoth,Berkshire Hathaway (BH) announced it would invest US $ 5 Billion in preferred stock of Goldman Sachs and would receive 10% annual dividend.It would also be alloted warrants that would give it an option to invest a further US $ 5 Billion in Common Stock at a strike Price of US $ 115 to be exercised inside five years
This was seen at the time as a WB Confidence booster for the US Financial System and the Share Price of Goldman Sachs closed high at US $ 133 after the announcement
What it apparently was,was just a consequence of the tottering US Financial System….The Share Price of Goldman Sachs has since dived to close at US $ 69 yesterday with a Market Cap now at a low of US $ 27 Billion
There are strong suggestions that this Investment in Goldman Sachs is linked to the Mark to Market Loss Margins on the Bets on S & P 500 and three other Foreign Indices made by WB’s BH in 2007 when Dow Levels were around 13000…Dow has since dropped to 8500 levels
This is the Bets that WB’s BH has made in 2007…he has bet that in the next 15 to 20 years the S & P 500 and three other Foreign Indices would be at higher levels than around the levels at the time the bet was made..BH has used Goldman Sachs as the Broker and has sold Option Contracts of ‘Naked Puts’ and got a premium aggregating US $ 4.5 billion for underlying contract values of US $ 37 Billion to a group of undisclosed buyers
As BH has impeccable credit it was not required to put up any collateral margin at the time of the bet in 2007.However alongwith the Dow which has fallen to levels of 8500,so have all the four Indices on which the bets were made and there is a mark to market loss of around US $ 6.7 Billion till date and the Counter Parties were demanding that Goldman Sachs put up some collateral
Reportedly this Collateral has been provided and disguised by BH as an Investment of US $ 5 Billion in preferred stock of Goldman Sachs
Apparently Mislead Investors,mislead by leading Investment Experts and Investment Media had followed WBinto Goldman Sachs in September and October 2008 at over US $ 100/share…They have seen an erosion of 40% inside two months
SEC must investigate and exonerate WB if this is not true….but the blemish does remain that a Living Investment Legend like WB has drifted away from his Value Investment Philosophy and speculated with Index based Derivative Instruments…which he has constantly cursed as Weapons of Mass Destruction…the temptation was probably just too much and US $ 4.5 billion premium received looked at the time as money for jam…Of course if the Dow revives and crosses 13000 in the next 15 to 20 years,BH would be back in the money as there will be a recovery of the S & P 500 and the other three Foreign Indices too…till then it’s a notional loss supported by a collateral margin now
As Notional Loss on Derivative Contracts have to be reflected in the Books,Berkshire Hathaway is already feeling the brunt in reporting 2008 earnings…It’s no wonder It’s share price has dropped over 30% this year from a high of @ US $ 150000 a year ago to the current US $ 102000…back to the 2003 levels…Portfolio Investments too have seen huge erosion in value and also contributed to a fall in the share price
While Warren Buffet assures shareholders of BH that as they hold the Money there is no counter party risk (See his Annual Note Below),the situation is actually the other extreme now,with the Indices down 35% from the levels at which the bets were made in 2007….Now the Counter parties see BH as a risk and pressurised Goldman Sachs to put up the collateral
Warren Buffett also discloses in his Annual Note that these ‘puts’ are only exercisable on their due dates from 2019 to 2027 and not before….he has taken a Bullish Bet against the parties that have bought these naked puts fom him and who consider that Markets will be much lower 15 to 20 years from now than they were in 2007 when these contracts were entered into….This bearish call is a huge one as these parties have paid this US $ 4.5 Billion premium to BH….WB goes on to say that BH will receive substantial income from Investments they make from this Premium they have received…However the truth is that they may have been forced inside a year to make this Investment of US $ 5 Billion in Preferred Stock of Goldman Sachs,albeit with a 10% annual return build into it.
There was absolutely no need for WB and BH to have indulged in Derivative Play by selling these ‘Naked Puts’….One can say that the Cash Inflow through Premium received in 2007 on selling the ‘Puts’ has now been offset by this Cash Outflow through Investment in 2008 in Goldman Sachs that caps the annual return at 10% for BH…On top of this is the Liability of US $4.6 Billion recorded at year end 2007 to reflect a Mark to Market Loss Situation and required to be reflected in the Accounts under stringent and mandatory Derivative Accounting Norms
If Markets slip significantly further will WB and BH again be pressurised to put up more disguised collateral with Goldman Sachs ?
The second category of contracts involves various put options we have sold on four stock indices
(the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.
Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.
Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.
Thus, our derivative positions will sometimes cause large swings in reported earnings, eventhough Charlie and I might believe the i ntrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter –and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.