Saturday, January 24, 2009

How the Mighty Have Fallen

Remember back a few months ago -- late in September, 2008 to be more precise -- when billionaire investor Warren Buffett made those two big investments ($5 billion and $3 billion, respectively) apiece of preferred stock in Goldman Sachs and General Electric? Remember how everyone (myself included) was saying what a genius he was, how the Oracle of Omaha got "incredible value" out of the two companies with his interest-bearing preferred shares in addition to warrants to purchase an equal additional amount on top of the companies' common stock at their then-current market values? I recall Goldman shares jumping about $15 on the news the following day, giving Buffett a paper gain of nearly $450 million on day one after that deal, swelling to over $800 million another day or two later at GS shares continued to rise following Buffett's bullish bet and seemingly reliable statement about the value in the stocks with Goldman at $115 and GE at $22 a share. Given all the positivity about these purchases, within a few days after the GE purchase, the later of the two big preferred stock buys out of Berkshire Hathaway (Buffett's investment vehicle), Berkshire shares were trading at $138,500, just a stone's throw away from his company's all-time high of $149,000 and change.

My how the mighty have fallen.

On Friday morning, BRK-A shares are trading under $86,000 for the first time since the late November lows in the market. From $138,500 to $86,000, that marks a loss of 39% in just three and a half months for the investment vehicle of the man many consider to be the greatest living investor in the world today. But that 39% figure doesn't tell the whole story until you can assign some real dollars to those amounts. On October 3, 2008, BRK-A was worth $220 billion in the market, and today that value has plummeted to $134 billion. How's an $86 billion haircut sounding to you these days? Even to a guy with Warren Buffett's bank accounts, that's a fuckload of dough, no two ways about it.

Let's look at just what we know Buffett has lost recently in his investment portfolio:

Goldman Sachs shares have plunged 38% since Buffett bought in to his preferred share investment at $115 a share. Although his up-front investment was in preferred and not common stock, it's reasonable to assign a similar drop in value to those preferred shares, which means his $5 billion investment in DS has deteriorated to about $3.1 billion, for a nearly $2 billion loss. Plus, those warrants to buy an additional $5 billion worth of GS common stock at $115 a share aren't looking so hot right now either, although with a five-year time horizon stipulated in the deal, it is likely that those will be exercised for some value before those warrants expire. Looking at the $3 billion of GE preferred stock that Buffett bought at $22 a share, GE common stock has now dropped 44% since that investment was made, leaving Berkshire's $3 billion now worth roughly $1.7 billion, plus again warrants to buy additional common shares anytime in the next five years at $22 a share (GE currently trades at $12 and change). That means Berkshire's holdings in just Goldman and GE are down nearly $3.7 billion on an $8 billion investment, not even counting the loss of value in the warrants that came as part of both purchases.

These are the most prominent of Buffett's recent purchases in his Berkshire Hathaway investment vehicle, but they are far from his only (or even his largest) losses. Berkshire owns over 300 million shares in Wells-Fargo, a position which alone has plunged nearly $4.5 billion just in the past seven weeks. His stake in fellow American bank US Bancorp has declined by over a billion dollars in that same timeframe as the banking sector has been trashed on Wall Street. Berkshire also has a roughly $2.5 billion position in Burlington Northern Santa Fe, a railroad company, whose shares have been nearly cut in half since last summer, equating to another $2 billion + loss.

One other area of Buffett's investments over the past year or so that deserves mention but has gotten very little focus in the media is the index derivatives position he has taken with Berkshire Hathaway. From late 2007 to early 2008, Buffett has disclosed that Berkshite Hathaway sold put options on the S&P 500 and three foreign indices to various financial institutions looking to hedge bullish bets on the global long-term economy. According to Buffett's disclosures, expiration of these puts range from 12 to 20 years out, and Berkshire collected $4.5 billion in premiumsin exchange for the sales. Using the 2007 closing level of the S&P 500, selling these puts is essentially Warren Buffett saying to the parties to whom he sold these index derivatives, "In 15 years, I promise to buy the S&P 500 from you at a price of 1468, if it trades below that price. In exchange, you give me $4.5 billion cash right now." Mind you, the S&P 500 currently trades at just over 800, having reached as low as 752 in late November.

Given the 12-20 year time horizon, it is still far too early to conclude that Berkshire will actually have to pay out on these puts (and we have no idea how large they are in any event -- we only know that the premium payment is $4.5 billion, so it is clear that we are talking about many, many, many billions of dollars here). The S&P 500 would essentially have to be lower than 1468 in the year 2019 in order for Buffett to have to pay out those huge amounts on these derivatives, but let's be honest: that possibility seems a whole lot more realistic today than it could ever have looked back 12 or 18 months ago. A whole lot more realistic. As a result of the market's declines since Berkshire sold these large index put options, Berkshire is surely sitting on a massive paper loss on this position, of an unspecified amount that must be at least 11 figures. That's right -- I said eleven figures. Don't bother counting that one out, I'll just let you know how much that is since this isn't a number of figures we ever hear anyone talking about. Berkshire's unrealized losses just in those index puts sold last year amount to somewhere in the tens of billions of dollars.

So so far, this incredible market correction we have seen over the past year and a half or so has spared no one, not even the greatest investors the world has ever seen. With Warren Buffett's investment vehicle having lost nearly $90 billion of its $220 billion market value just since October 2008, it is clear that anybody and everybody is taking it on the chin with this thing. When stocks decline like they have, I like to take the approach that Buffett himself espouses, which is to look for values and buy in cheap while the gettin is good, and I've been doing that selectively over the past several months. But the carnage Buffett has suffered while attempting to catch the bottom over the past few months serves as a great example of just how difficult it can be trying to pick a bottom in a bear market. There's a reason this is known as "trying to catch a falling sword". Buyer beware.

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Blogger Bayne_S said...

I thought expression was "Don't catch a knife"

1:28 AM  
Blogger Astin said...

Yah, it is Bayne. But that's about the least of the errors in this post.

Hoy, you really need to do some research on preferred shares, options, derivatives, and the concept of unrealized loss.

It is entirely NOT reasonable to assign a similar drop to his preferreds as to the equity. Preferred shares base price aren't a function of the underlying equity, but the interest rates as a whole. With rates at historic lows, the prefs don't need to trade at a discount to be an attractive vehicle. On top of that, they are EARNING GUARANTEED INTEREST for Buffett. He's likely made money on the prefs, and in the unlikely event that GS or GE actually go under, he's ahead of every single stockholder for recompense from the liquidated assets (but behind the debtholders). In fact, if the series Buffett owns was created specifically for him, then there isn't even an open market to price these prefs at.

The warrants, with a 5 year window, are also in no danger of being considered a loss. Companies like GS and GE can swing up wildly during a recovery, and $115 for GS and $22 for GE are not unrealistic prices for them to reach. Remember, GS was up as high as $208 on artifical wealth, so 55% of that value is easily a believable valuation. GE was at $38, so $22 is 58% of that level. If it even comes close, he can recover a fair bit of the cost by selling the warrants at a small discount. Plus, the 10% he's earning on the Prefs will more than cover the costs by that time.

As for the put options, are they European or American (and if you think that refers to the country of origin, you're wrong)? From your description, they sound like either multiple Europeans or a combination, where they become American after 12 years. Running on that assumption, a lot can happen in 12 years. In that time, I'm pretty sure he can turn that 4.5 billion in his pocket TODAY into a hefty sum itself. That's assuming the puts are naked, which is NOT something Buffett would likely do. I imagine he covered that position around the same time he wrote the options, or (more likely) already had a position on the indices, and will realize a profit no matter where he buys them back when/if those options are exercised.

Superceding all of that is that he hasn't lost a DIME until he actually sells these positions. He has REALIZED $4.5 billion from the put sale, and has regular income being generated from the prefs. He's making REAL money on this, and has only lost paper value. An investor like Buffett doesn't give a rat's ass about where his valuation is a few months after purchashing. He's got a 10-20 year horizon on these, and isn't losing a wink of sleep over that or the price of B-H. I imagine most of the B-H investors aren't either.

He hasn't tried to catch a falling knife, he's sidestepped it and sold insurance to the people below him who have their hands out.

1:54 AM  
Blogger Micah Seymour said...

Damn Astin, I don't know enough about this stuff to judge, I'm just a lowly sysadmin, but I think you just turned up quads over Hoy's boat with the sidestepping the knife analogy.

5:25 AM  
Blogger Brian said...

Judging the short-term results of what are long-term investments is pretty useless at this moment.

Those derivatives are OTM naked puts. I believe the strike was 30% lower than the indexes were at the time the options were written, so that would make them in-the-money at this moment.

But there's a catch! They are European (can't exercise until expiration), and the first one doesn't expire until 2017 or so. Unless we get hit with a decade long depression, than Berkshire will probably not pay a dime.

Secondly, the maximum loss that Berkshire can take from these derivatives is $35 billion, if all the indexes go to 0. What are the chances of that? And if they did all go to 0, we'd have much bigger problems to worry about.

11:13 AM  

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