Felix Salmon
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I just got off the phone with someone who's been making good money shorting Berkshire Hathaway (BRK.A) stock in the past few weeks; he pointed out to me something very peculiar in Berkshire's public statements.
First, look at the 10-Q for the second quarter, ended June 30. Have a look at page 24, where the company talks about its equity put options:
At June 30, 2008, the estimated fair value of these contracts was $5,845 million and the weighted average volatility was approximately 23%.
It then goes on to say that if volatility were to rise by 4 percentage points, the value of the contracts would rise by $1.124 billion, to $6.969 billion -- a rise of $281 million per percentage point.
It's not clear where Berkshire is getting its volatility numbers from, but the VIX volatility index, as of June 30, was at 24 -- which means that Berkshire's volatility number was pretty much in line with the VIX.
Now look at the 10-Q for the third quarter, page 25. Over the course of that quarter, the VIX rose substantially, from 24 to 39 -- so one would expect Berkshire's own volatility numbers to rise as well. But they didn't. In fact, they fell, slightly:
At September 30, 2008, the estimated fair value of these contracts was $6,725 million and the weighted average volatility was approximately 22%.
Stock markets fell by about 9% over the course of the third quarter, which would explain why the value of the put options rose even if volatility fell, as Berkshire seems to think that it did. But of course volatility rose substantially during the quarter, and it looks as though Berkshire is using an improbably low volatility number here.
In the third quarter 10-Q, Berkshire reckons that the value of its put options goes up by about $250 million for every percentage-point increase in volatility. The VIX is now at 80, but the VIX is much more short-dated than Berkshire's equity puts. But let's say that a reasonable volatility number for Berkshire would be somewhere around 50: That would mean the value of those equity puts going up by about $7 billion, before taking into account that the S&P has fallen by a good 35% since September 30.
Add it all up, and Berkshire's equity puts alone should probably have gone up in value (this is value to the holder of the puts, which means it's a liability to Berkshire) by $15 billion or so since the end of the second quarter. Now this is a noncash loss, and Berkshire doesn't need to post any collateral or otherwise lose liquidity as a result of any such losses. But when Whitney Tilson says that "there could be an additional $1-2 billion in mark-to-market, noncash losses so far this quarter", he could be underestimating greatly.
On the other hand, he might be right: Berkshire might end up taking only a relatively small markdown of one or two billion or two dollars on those equity put contracts. But if it does so, questions will continue to be asked about why Berkshire's volatility numbers stubbornly refuse to rise even as every other volatility number in the world is going through the roof.
Essentially, the shorts' argument is that Berkshire is short volatility, thanks to these puts, and that being short volatility has been a very, very bad trade over the past few months. Berkshire is in the happy position of not needing to take any cash losses on its short-vol positions, and it's entirely reasonable for long-term shareholders (and most of Berkshire's shareholders are long-term shareholders) to just want to ride out the present craziness. All the same, on a mark-to-market basis -- and it's entirely reasonable for the stock market to be marking Berkshire's assets to market -- it makes sense that Berkshire's share price should be falling to reflect the mark-to-market losses on its equity puts, not to mention similar mark-to-market losses on its CDS, bond-insurance, and deposit insurance portfolios.
Now Berkshire's lost a lot of market capitalization of late: about $77 billion, in fact, since September 30. So it's entirely possible that mark-to-market losses on its equity puts and other derivatives contracts have been more than priced into its shares. But it'll certainly be interesting to see how Berkshire values those puts in its next quarterly report. If the volatility number rises to something a bit more reasonable, Berkshire could end up reporting a quarterly loss -- and that might spook quite a few investors.
Update: Many thanks to Andrew Clavell, who send me some long-term volatility numbers. They seem to be around 38%, which is a big spike up from the 22% which Berkshire used in its last 10-Q. Combine that with the drop in the S&P, and you could see a big noncash hit to earnings in Berkshire's next quarterly report.
It's worth noting, however, that long-term volatility at 38% implies a random walk in the index of near 2.5% every trading day for the next 20 years. If and when that number comes down, Berkshire's noncash losses today will simply be cancelled out by noncash profits tomorrow.
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This article has 8 comments:
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DonSuper
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51 Comments
Nov 21 08:55 PM-
Muzie
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103 Comments
Nov 21 09:00 PM"
And this is where I'm lost as to why this affectes any of the company's valuation at this point. We're talking imaginary dollars here no? Even if these are marked to market, shouldn't these outflow be discounted twnety years in the future, making them rather muted?
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Muzie
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103 Comments
Nov 21 09:02 PM-
sunil94062
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9 Comments
Nov 22 09:09 AMNo later than next spring, I feel many of the risks will become non-risks and thus the market will become more stable.
As it is the global rout in equity values is on par with the projected losses - I think we have shed about $12T in global tangible (equity & real estate) value - and not everything is going to zero, or falling off the face of the earth!
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MurphMan
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51 Comments
Nov 22 09:47 AM-
Swiss Investor
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18 Comments
Nov 22 01:45 PM-
happysoul77777
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65 Comments
Nov 22 04:42 PM-
cellardoor1
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5 Comments
My Website
Dec 04 10:56 PMb)from most recent 10-Q:
-mildly interesting is the fact that he now comments "Berkshire’s equity index put option contracts are European style options and at inception had durations of 15-20 years." This seems to suggest that sometime in the last 9 months, he wrote some puts that had duration of something _other_ than exactly 15 or 20 years
-another calibration point: "[T]he weighted average remaining life of [BRK's put option] contracts was approximately 13.5 years"
2.Re: your revision for long-dated vols from Andrew Clavell above – can you shed some additional light on the actual timespan/index/source of data?
Since I can’t say for sure what he’s referring to – as far as I know (off random Bloomberg searching), some of the longest-dated, exchange traded (non-OTC) options out there are probably December 2017 expiry eurostoxx index puts. Note that these are still too shortdated for BRK’s average put option. (Also, apply some transformation to the long-dated vols stated below to adjust for differences in short term implied vols between eurostoxx and S&P-based options.)
The thing is, what’re these things (or Clavell’s reference securities) actually transacting at? Assuming that no one’s actually transacting (as is so often the case in super-illiquid options markets), or at best, transacting in tiny size when someone crosses the mid, it means that the implied vol that far out is at best a hack of average (highest bid, lowest offer). You might argue that this is the case for any market – but when we’re talking about stuff this far out, even small potential asymmetries in bid vs offer prices hugely skew the mid – and if I had to guess, the supply demand balance between sellers and buyers of super-long-dated vol has gotta be in favor of the sellers (BRK aside).
Also, off Bloomberg for the 3000 strike dec2017 eurostoxx puts, all I can view is implied volatility using best price, which may be equally bad/even worse(“Measure of the volatility of the underlying security. The implied volatility is determined by using the underlying security's last trade price and the option best price currently existing in the market, rather than using historical data on the price changes of the underlying security.”) – but note that this is currently at 26.43%.
Let’s get back to the concept of actual arms length transactions pricing being the best determinant of implied vols (rather than mid, etc) -- the thing is, BRK has continued to successfully sell these puts during 2008 – and obviously in ridiculous size compared to the total market for such contracts (tho only a tiny amount compared to their total put sales over the last 5 years or so). To the degree that they’re probably still willing to sell at “low” (22-23%) vols, and no one else has been able to transact such things, they have pretty good justification for the pricing to be wherever they sold at.
Not that I think BRK is doing this to manipulate prices, but insofar as few people have the wherewithal (or insanely advantageous margin agreements) convince buyers to accept such an OTC contract for 20 years – where the buyer is exposed to the seller’s credit risk, rather than an exchange’s, and not get paid _any_ margin no matter how much money the seller owes – BRK can basically set market price via actual transactions, wherever they want (as long as they don’t price too aggressively and still find people willing to take on the other side).
3.Also, pretend there are exchange traded puts of the same lengthy duration as the ones that BRK sold. Comparing them to the one’s sold by BRK (not through an exchange), side by side, one would _expect_ the price of the ones BRK sold to be much lower.*
After all, you’re buying puts from someone who never posts collateral (short of downgrade in credit rating), no matter how much money s/he loses, rather than removing counterparty risk through exchange-based purchases. The fair economic value for such puts _should_ be lower. And, since implied vols are mechanically generated from price and other inputs, the implied vol of the OTC option sold by BRK _should_ be lower than that of the identical exchange-traded contract.
*-unless you think, perhaps rightly, that there may be less counterparty risk from BRK than the options clearinghouse/exchange – even after adjusting for mortality vs govt bailout likelihoods
4.The less tongue-in-cheek point here is that all those puts that buffett sold have embedded exposure to BRK credit risk (because of the collateral posting terms).
Insofar as people _think_ that BRK is more likely to blow up (check out the numerous articles on BRK CDS spreads blowing out) -- guess what -- it's consistent for those puts to get marked down in value.
5.Here's something that's maybe a bit more valid (or at least more interestingly incorrect):
if you think that we're about to enter a long-term deflationary cycle, since these puts are struck in nominal terms, the expected amount that BRK could be on hook for in 15 years might be much larger than current 10-15 year bond yields seem to imply. For that matter, the whole BRK business model of snagging cheap float up front starts looking a whole lot worse...