Wednesday, November 19, 2008

Berkshire's Credit Risk Soars on $37 Billion Bet

(Bloomberg) The cost of protecting against default by Warren Buffett's AAA rated Berkshire Hathaway Inc. has almost tripled in two months, a sign of just how skittish investors have become amid the global financial crisis.

The cost to protect against Berkshire being unable to meet its debt payments, based on credit-default swaps, is more than four times that of rival insurer Travelers Cos. At those levels, the swaps are typical of companies rated Baa3 by Moody's Investors Service, one level above junk. The price may have risen on concern that the billionaire's firm could lose a $37 billion bet on world stock market values more than a decade from now.

``That's just so stupid,'' said Mohnish Pabrai, head of Pabrai Investment Funds and a Berkshire shareholder. The swap buyers are projecting ``present circumstances into infinity'' and concluding Buffett's bet will cost the company $40 billion, Pabrai said. ``It will never happen,'' he said.

For the swaps to pay off, Berkshire would have to exhaust its $33.4 billion cash hoard, and Buffett's decades-long record as the world's most successful investor would have to come to a cataclysmic end. President-elect Barack Obama seeks him out for advice and the world's biggest firms, including Goldman Sachs Group Inc. and General Electric Co., turned to Berkshire for capital and the prestige that comes with Buffett's backing.

Buyers of default protection are being charged 1.45 percentage points more for Berkshire swaps than for insurance against Allstate Corp. Allstate last month had its credit grade cut by Fitch Ratings after hurricane claims and declines in its investments caused a $923 million third-quarter loss. Berkshire has remained profitable amid the worst financial crisis since the Great Depression, and wouldn't pay out on its stock market bets, if it lost them, until at least 2019.

Unlikely Target

``If you were going to start picking companies that are going to default, you probably wouldn't put Berkshire at the top of the list, so it's totally unexpected to see them there,'' said Jeff Matthews, author of ``Pilgrimage to Warren Buffett's Omaha'' and founder of Greenwich, Connecticut-based hedge fund Ram Partners LP. Of the swaps, he said: ``I wouldn't buy them, and yet it's there.''

Standard & Poor's said Buffett's bet on the stock indexes wouldn't cause a liquidity crisis. Berkshire spokeswoman Jackie Wilson said she had passed along requests for comment to Buffett. The stock fell below $100,000 a share for the first time in two years last week and has dropped about 33 percent this year.

Buffett's Bets

The cost of protection on Berkshire debt has jumped to 415 basis points from 140 basis points two months ago, according to CMA Datavision. That translates to $415,000 a year to protect $10 million for five years. The median for companies rated Baa3 was 348 basis points yesterday, according to data from Moody's capital markets research group. Credit-default swaps, used to hedge against losses or to speculate on the ability of companies to repay their debt, rise as investor confidence deteriorates.

The increase may be tied to a series of bets that Buffett has taken on four stock indexes across the globe, including the Standard & Poor's 500 Index, according to Berkshire shareholders. Buffett sold contracts to undisclosed buyers for $4.85 billion that protect the buyers against declines in those markets.

Under the agreements, Berkshire will pay as much as $37 billion if, on specific dates beginning in 2019, the market indexes are below the point where they were when he made the agreements. By Sept. 30, Omaha, Nebraska-based Berkshire had written down the contracts by $6.73 billion as the S&P declined for a fourth straight quarter.

`Greater Gains'

``I believe these contracts, in aggregate, will be profitable,'' Buffett said in a statement in May, reiterating comments from his letter to shareholders in February. ``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.''

A total of 2,450 credit-default swaps had been sold on Berkshire as of Nov. 14, protecting a net amount of $4.7 billion, according to data from the Depository Trust & Clearing Corp., which runs a central registry for the derivatives.

Buyers of derivatives typically aren't disclosed, and representatives at 20 potential buyers including insurers and pension funds either didn't know who was involved or declined to respond.

Buyers of the credit-default swap protection on Berkshire may include the companies that stand to gain if Buffett loses on the stock bets, said Matthews. They may be hedging their gains against Berkshire by entering into separate agreements to ensure they recover some funds if Berkshire is unable to pay, he said.

`Mass Destruction'

The increase in perceived credit risk contradicts Buffett's record of building Berkshire over 40 years from a failing textile maker into a $145 billion company with businesses ranging from carpet making to utilities.

Buffett has at times decried derivatives as ``financial weapons of mass destruction'' and criticized their complexity and popularity. Berkshire hasn't disclosed which stock indexes besides the S&P are covered under the contracts or how they're structured.

Berkshire, which typically gets about half its profit from insurance, on Nov. 7 posted its fourth straight quarterly profit drop, the longest streak of declines in more than a decade, on hurricane costs and investment losses. Further declines in debt and equity markets reduced shareholders' equity, a measure of assets minus liabilities, by $9 billion in October, after the third quarter ended, the company said.

Berkshire's stock decline this year compares with a slide of 41 percent in the S&P 500. Berkshire shares rose in 17 of the past 20 years.

Not `Crazy'

Buffett may use the $4.85 billion paid to Berkshire in the derivative deals to buy stock or make acquisitions.

``Shareholders should rejoice that he was able to obtain that capital to invest on such attractive terms for years before the chance comes that he'll have to pay,'' said Tom Russo, a partner at Gardner Russo & Gardner, whose largest holding is Berkshire stock, in an interview this month. Still, he said, the increasing cost of Berkshire credit protection in the swaps market ``isn't crazy in light of the way the markets performed.''

American International Group Inc., the insurer that needed $150 billion from the U.S. government to stay afloat, nearly was forced into bankruptcy by derivatives. As credit rating firms lowered their grades on AIG, the New York-based firm was required to post collateral to show it could meet its obligations to the counterparties who took the opposite side on their bets.

No Collateral Damage

Berkshire may have to post collateral on some derivatives ``under certain circumstances, including a downgrade of its credit rating below specified levels,'' the firm said in a regulatory filing this month. Damien Magarelli, a credit analyst for Standard & Poor's in New York, said the losses are merely an ``accounting loss.''

``They've had no collateral requirements to date and the losses are not viewed by us as a cash loss,'' Magarelli said. ``It is not something that would be creating any type of liquidity issues or near term cash payments.''

Berkshire's AAA rating is the highest available. ``If Berkshire isn't triple A, I'm not sure which company would be,'' Buffett said in May.

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