Lehman Brothers Maybe Sold Warren Buffett a Rainbow

[hyten1]

interesting

 

http://www.bloomberg.com/news/2014-02-06/lehman-brothers-maybe-sold-warren-buffett-a-rainbow.html

[ItsAValueTrap]

There's an excellent lecture about derivatives and Buffett's use of derivatives here:

http://video.mit.edu/watch/doug-dachille-analysis-of-buffetts-love-hate-relationship-with-derivatives-3802/

 

I think that the journalist who wrote the bloomberg article is mistaken.  The derivative deals are a good deal for Berkshire.

 

You get float upfront.  You can invest that float and make a return on it.

In 20 years, it is unlikely that the derivative contract will pay off.  These indexes are of publicly-traded companies that are all trying to make money.  Over time, those companies will probably make lots of money.  Their share price will likely be much higher than today even if there is a market crash.

 

And then you have the float, which should make more money than what you'd lose on the derivative contract if it happens to be a loser.

 

If there is worldwide inflation, then the contract is less likely to pay off.  If one index goes to hell because of a Germany-style hyperinflation, the derivative contract won't pay.

 

There's no counterparty risk for Berkshire AFAIK.

[ItsAValueTrap]

Another way of looking at it.

 

Berkshire gets $205M in premiums.  It invests that at a 8.246% return.  In 20 years, that $205M will grow into a billion dollars which is the maximum possible loss on the contract.

 

Berkshire is almost guaranteed to make money on the derivative contract.

[Green King]

Another way of looking at it.

 

Berkshire gets $205M in premiums.  It invests that at a 8.246% return.  In 20 years, that $205M will grow into a billion dollars which is the maximum possible loss on the contract.

 

Berkshire is almost guaranteed to make money on the derivative contract.

 

Got any more good talks you care to share.

[zarley]

There's an excellent lecture about derivatives and Buffett's use of derivatives here:

http://video.mit.edu/watch/doug-dachille-analysis-of-buffetts-love-hate-relationship-with-derivatives-3802/

 

I think that the journalist who wrote the bloomberg article is mistaken.  The derivative deals are a good deal for Berkshire.

 

You get float upfront.  You can invest that float and make a return on it.

In 20 years, it is unlikely that the derivative contract will pay off.  These indexes are of publicly-traded companies that are all trying to make money.  Over time, those companies will probably make lots of money.  Their share price will likely be much higher than today even if there is a market crash.

 

And then you have the float, which should make more money than what you'd lose on the derivative contract if it happens to be a loser.

 

If there is worldwide inflation, then the contract is less likely to pay off.  If one index goes to hell because of a Germany-style hyperinflation, the derivative contract won't pay.

 

Outstanding link. Thanks for sharing.

[value-is-what-you-get]

As I recall, the mark to market provision also gave him some excellent tax losses in the first couple of years as well.  Essentially additional float in the form of cash taxes not paid.

[netnet]

The only thing in that article that is really "true" is that this is old news.  The guy's analysis is so wrong as to be laughable. 

 

From the article:

But when that happens, the bank will pay for protection. It is buying a service, and the service costs it money. And that's not what happened here. Berkshire's services did not cost Lehman money. Lehman made a $16.5 million profit the day it did this trade.

 

Lehman paid for this (in more ways than one).  To book a immediate profit on the trade has been a common, if dodgy practice that both Warren and Charlie have critiqued.  The trading desk booked the profit which counted on the that quarter's PL.  From the trader's perspective what's not to like? 

 

The real deal BK gets relatively cheap float for years.  From a BK perspective, i.e. long term and corporate, what's not to like?

[Kiltacular]

The only thing in that article that is really "true" is that this is old news.  The guy's analysis is so wrong as to be laughable. 

 

From the article:

But when that happens, the bank will pay for protection. It is buying a service, and the service costs it money. And that's not what happened here. Berkshire's services did not cost Lehman money. Lehman made a $16.5 million profit the day it did this trade.

 

Lehman paid for this (in more ways than one).  To book a immediate profit on the trade has been a common, if dodgy practice that both Warren and Charlie have critiqued.  The trading desk booked the profit which counted on the that quarter's PL.  From the trader's perspective what's not to like? 

 

The real deal BK gets relatively cheap float for years.  From a BK perspective, i.e. long term and corporate, what's not to like?

 

+1

[randomep]

Another way of looking at it.

 

Berkshire gets $205M in premiums.  It invests that at a 8.246% return.  In 20 years, that $205M will grow into a billion dollars which is the maximum possible loss on the contract.

 

Berkshire is almost guaranteed to make money on the derivative contract.

 

This is so interesting I am going to read it several more times to really understand. But the 8.246% return will pay for the loss is not a correct analysis I think. The 8.246% return is correlated to the probability of loss on the contract. Or looking at it another way if Berkshire has a big loss on the contract, then the whole world is screwed and Berkshire won't be able to make 8%.

 

But ya I can't fathom how Lehmans can accurately forecast the price of a 20yr put now to 5% of the premium! jeeze

[WolfOfMainStreet]

I don't know much about this stuff but I have a curious question. What other incentives are there for Lehman to do this deal other than the $16.5 million "profit"? I mean it seems that the worst case scenarios are highly unlikely and the "profit" is relatively low. Also, how would you know how much of a bank's or investing institution's profits are due to futures and derivatives? Is there a sort of term or measurement that aggregates these profits but separates them from others such as lending and insurance? I'm pretty much a newbie when it comes to this stuff and I'm just trying to grasp the concept.

[ItsAValueTrap]

Watch the Doug Dachille lecture and read Buffett's letters on derivatives.

 

Is there a sort of term or measurement that aggregates these profits but separates them from others such as lending and insurance?

Derivatives will show up as level 3 assets.  But as Buffett says, it is difficult to judge risk without going through a company's derivatives book.

 

On the other hand, Buffett has invested in Goldman Sachs via the preferred shares... Goldman likely has a derivatives book.  So that's mostly a bet on them not being stupid with derivatives (and the government bailing them out).

[jay21]

Another excellent write up: http://ftalphaville.ft.com/2014/02/24/1777512/buffett-derivatives-feel-the-credit-quality/

 

I didn't know this:

 

"In Q2 2009, Berkshire did just that and modified six put contracts, mostly referenced to the S&P. Maturities were reduced between four and ten years, and strikes were reduced between 29% and 39%. In the specific case of the amended S&P puts, maturities went from 18 to 10 years and strikes from 1500 to 990 (the index was below 900 at the time, so the original strikes were massively in-the-money; the original notional amount of those puts reportedly was $2 billion)."