Berkshire's misunderstood derivatives book and obvious undervaluation

[mpauls]

The following is only a small part of the attached document/b]

Image quality is bad due to file size restrictions.  pm or email me for the higher quality file. 

 

 

 

Berkshire Hathaway is Misunderstood & Inexpensive

 

Buffett goes out of his way to make Berkshire Hathaway’s Annual Report as easily understandable as possible.  However as Berkshire Hathaway has grown, complexity followed.  This makes putting a price or value on Berkshire increasingly difficult for both the average and professional investor.  Complexity coupled with Buffett’s advancing age, not to mention skittish markets, certainly play a role in Berkshire Hathaway’s depressed market price.  I will try to break down Berkshire Hathaway’s separate components of value below.  The discrepancy between price and value should become very apparent. 

 

The 4 major sources of value may be specified as follows:

 

Insurance business

Utilities and Energy Business

Service, Manufacturing, and Retail Business

Finance and Financial Products Business

 

The Utilities & Energy businesses and Service, Manufacturing, & Retail businesses are fairly straightforward as far as we are here concerned.  The real complications derive from the insurance businesses and the Finance and Financial Products Businesses.

 

Part I    Finance and Financial Products

 

Over the past 2-3 years, Berkshire made a few investments in derivatives contracts, which leaves many people scratching their heads. Mark-to-Market, “Fair Value” accounting (Used for Derivatives) causes wide variations in the balance sheet and income statement and produces misleading results.  There are four different types of derivative contracts in which Berkshire has entered.

 

i)   Equity puts

ii)  Credit Default Insurance on a high yield index of 100 companies

iii) Credit Default Swaps on individual companies

iii) Tax Exempt (Muni) Bond Insurance Contracts (Structured as Derivatives)

 

 

Equity Puts

Berkshire Hathaway sold equity puts.  Equity puts are very similar to selling insurance-the purchaser pays a premium and in return is protected from future loss.  The loss in this case is a decline in the general stock market.

 

Berkshire sold puts and collected premiums up front which Buffett invested.  These premiums, like insurance, are invested until the contract expires.  These are European style contracts, meaning the seller is liable only for losses that exist on the expiration date of the contract, which is in no less then 15 years.  In the meantime Buffett gets the benefit of the use of this money.

 

Specifics:

 

2006 seems to be the first year that Buffett personally entered into equity puts.  In 2006 the S&P 500 closed at around 1400, as of early March 2009, the S&P 500 stands at 830.  Premiums received for these contracts, $4.9 billion.  Max loss if the index is zero upon expiration, 15 years hence (at which point money would be all but worthless anyway,) $37 billion.

 

 

Credit Default Insurance on a High Yield Index of 100 Companies

First expiration is due in September 2009 and the last expiration due is in December 2013.  Premiums received, $3.4 Billion.  The amount of actual losses paid as of December 31, 2008: $542 million.  Meaning, net, Berkshire has the benefit of the use of $3 billion.  This might be considered as “Credit Default Insurance (high-yield index,) Float”.  Estimated future losses (loss reserve) are $3.4 billion.  These contracts seem the most likely, of the 4 types of derivatives, to produce a “Derivative Underwriting Loss”.

 

 

Credit Default Swaps (CDS) on Individual Companies

Counter party risk exists to the extent the purchasers of these contracts are able to pay the full $4 billion premiums over the 5 year life of the contracts.  Annually Berkshire receives $93 million for premiums on these contracts.  Berkshire is liable for 42 corporations.  Should any of them default on their loans, Berkshire is liable for the decline in the market value of the debt relative to value of the debt specified in the CDS contract.  I am confident that each of these corporations has substantial amounts of tangible assets or have sustainable earning power well in excess of their respective interest obligations, both of which protect Berkshire from loss.  Asset protection protects the price decline in the market value of debt upon default and earning power from default.

 

 

Tax Exempt (Muni) Bond Insurance Contracts (Structured as Derivatives)

These are mostly second-to-pay contracts meaning Berkshire is liable to pay only what the first insurer cannot.  Berkshire received premiums of $595 million in 2008 on contracts extending as far as 40 years.  These premiums should be expected annually for the duration of individual contracts.

 

Berkshire has a total “Derivative Float” of about $8.1 billion primarily from Equity Puts and Credit Default Insurance (high yield index).   Current accounting requires Berkshire to record an excessive liability on its balance sheet for the Mark-to-Market changes in the liabilities that accompany derivate float.

 

 

Accounting for Derivatives

 

Derivatives contracts not designated as a hedge, for example sold European Style Equity Index Puts receiving (premiums up front) are accounted by recording premiums as “other liabilities” on the balance sheet.  Changes in the “fair value” of these contracts are adjusted quarterly with changes reflected in the income statement as derivative or “unrealized” losses and correspondingly in the in the balance sheet account as an increase or decrease in “derivative contract liabilities”.  A more detailed discussion on Berkshire’s Derivatives and the accounting is discussed on page 8.  What follows here is a more general, less confusing explanation.

 

The $8.1 Billion Berkshire received in premiums (“Derivative Float”) was initially recorded as a liability on the balance sheet and declines in the “Fair-Value” of “Mark-to-Market” securities are subtracted from earnings in the period of loss, irrespective of actual economic gains or losses.   Due to Mark-to-Market changes in the derivatives that Berkshire holds, their liabilities increased to $14.6 billion in 2008 and as a consequence a pretax loss of $6.821 billion was recorded as negative revenue (expense) understating reported earnings in 2008.  For similar reasons, earnings were overstated by $5.5 billion in 2007 and $2.6 billion in 2006 again due to the nature of Mark-to-Market ,“Fair Value” accounting.

 

Personally I believe markets will recover in a few years, let alone 15 years, but let’s first consider the contrary.  In December 1929 the Dow Jones Industrial Index was at about 370.  In 1934, 15 years later, the index had fallen a total of 60% i.e. a 6% annual loss.  In equivalent terms, Berkshire’s Equity puts would require payment of about $22 billion.  To break even on this transaction Berkshire Hathaway

 

would need to compound $4.9 billion at about 10.5%.  Buffett’s track record is well above 15% over the last 50 years and his current investments are certain to out live him-and I expect will exceed the breakeven 10.5% (Note the yields on “Other Investments” below).  If on the other hand in 15 years the stock market has at least recovered, there is no payment for loss and the derivative float will explicitly become equity.  In this case, the value of “Equity Put Float” will have definitely compounded at a rate exceeding 15%.  It appears reasonable to me that Berkshire’s “Equity Put Float” is today worth about $12.5 billion.  In the event that the market closes down 60% in 15 years, while (assuming) Berkshire continues to compound investments as it has in the past, the Equity Put Float would have a current value between $4 billion and $5.5 billion.

 

The below table shows Earnings and Net Worth as reported and adjusted for the affects of derivatives:

 

 

[mpauls]

p.s. "attached file" is hard to find. Here's a link for those with difficulty finding it:

 

 

 

[SharperDingaan]

 

You might want to google IAS 39 - how derivative gains/losses will be recorded starting 01/01/2010.

 

It is highly likely that much of the MTM gain/loss will go to Other Comprehensive Income, with the cummulative MTM gain/loss going to 'income', only when the instrument is actually sold. Materially changes income volatility.

 

We would suggest that Mr Market is penalizing for accounting earnings volatility, that may very well largely soon dissappear.

 

 

 

 

 

 

 

 

[mpauls]

It should disappear in investor's minds.  Accounting numbers should be taken with a grain of salt-restating them to make sense from an owners perspective. 

[el_chieh]

Thanks for the BRK analysis.

 

Off on a bit of a tangent, can you confirm that the equity put premium cash resides w/in "Financial Products"?  Your analysis seems to imply that it is.

 

I know the equity put liabilities are in "Financial Products" but where is the asset side?

 

I was just wondering whether Buffett's 2-column valuation ignores the equity put premium received (in my mind, it does ignore it if the cash for equity put premium is in "Financial Products").

 

I didn't think the equity put premium cash is in "Financial Products" due to the relative change from year to year of assets.

 

Thanks!

[mpauls]

"Your analysis seems to imply that it is."  Please elaborate.

 

 

[Stove]

I've noticed there has been a dearth of "Warren Buffett has lost it" articles lately.  Looks like they caught the bottom again.

[ubuy2wron]

I've noticed there has been a dearth of "Warren Buffett has lost it" articles lately.  Looks like they caught the bottom again.

 

 

After reading extensively the information in Deep Capture I believe that it is not a coincidence that there was a rash of articles re Mr Buffetts losing it I suspect this time however it was just to effect some attractive purchases as opposed to a short and cover strategy. These negative WEB articles were every where as was the story that many of the banks were about to be nationalized. I took advantage of it and bought some BRK for the first time thankyou manipulators whoever you are.

[el_chieh]

>>"Your analysis seems to imply that it is."  Please elaborate.

 

I just re-read your analysis, and it is not implied in it that the cash from the equity put premium is in "financial products".  I wrote my question a bit too quickly.  Sorry.

 

But my question remains, do you know where the cash from the equity put premium is?  Is it indeed in "financial products"?

 

Thanks.

[mpauls]

The answer to your question isn't an easy one. 

 

I'm sure you're aware of Berkshire's very complicated holding company structure. Subsidiary 'Z' might be owned by one or more other subsidiaries, (e.g. 51% by subsidiary 'X' & 49% by subsidiary 'Y').  In addition, their insurance businesses are constantly transferring assets between one another which makes identifying who holds which securities from year to year time consuming.  Its similarly hard to say on a division to division basis where exactly certain assets are held.

 

Ultimately I don't think this is too important-unless to offer peace of mind, but let's see if intuitively we can figure it out:

 

The finance and financial businesses (as presented in the annual report) that would potentially write derivatives are: Berkshire Hathaway Credit Corporation, Berkshire Hathaway Finance, and Clayton. 

 

I'll assume everyone agrees that the equity index puts were written by Berkshire Hathaway Finance.  Since cash received for the equity index put contracts are recorded in much the same way as insurance premiums (i.e. recorded as a liability) then the writer of the derivative contract would naturally record this as a liability on their financial statement, however, they may not be 'required' to hold the cash received therefrom at least not directly. 

 

To your question, I am almost certain that the equity index put float is invested by National Indemnity.  Why?  Berkshire Hathaway Finance Company's immediate parent is National indemnity.  As everyone is aware, a controlling entity can often allocate capital as desired.  In the case of certain restrictions (e.g. in the case of insurers only certain amounts may be paid out as dividends in any single period) there are ways for National Indemnity to invest this capital on behalf of Berkshire Hathaway Finance Co. (Entering into asset management agreements, etc.,). 

 

For reasons explained in 'the document' namely pgs 2-3, I referenced that these premiums were likely invested in, "Other Assets".  As it happens, the GE & Goldman Preferred's have been invested and are held by National Indemnity.  While we can't be certain that these investments were funded by Equity Index Put Float it would certainly make sense that the capital be allocated this way.  

 

 

 

 

 

 

[mpauls]

In response to: What is the effect of the new FASB ruling on mark to market?  (Apr 2, 2009)

 

If I correctly understand FASB’s revisions, it will allow banks to use more judgment in assessing the value of certain financial assets (e.g. CDO’s & other securitizations).  As many of you know, there are 3 classifications that determine which inputs are used to calculate an assets “Fair Value”.  Most securitized assets were level (tier) 2 and as such were calculated with respect to transactions of other similar assets.  The market for these assets completely dried up except for forced or distressed transactions like Lehman.    Meaning these distressed transactions drove down the Fair Value of other similar assets.  The next step was to determine whether these impairments were “Other-Than-Temporary” in which case the otherwise unrealized losses became, for the most part, realized and thereby charged against income.  This of course reduced banks regulatory capital.  Insofar as banks are concerned there are two components to the impairment charge-Credit & Noncredit.  Default would be credit, collapse in price due to illiquidity would be non credit.  The accounting provisions will, in essence, lift the noncredit losses off the banks income statement.  The noncredit losses go straight to Accumulated Other Comprehensive Income-a component of shareholder equity. 

 

With respect to Berkshire, I am of the opinion that there will not be a significant revision to their numbers.  For clarity I’ll assume we are referring to Berkshire’s non-cash derivative losses.  These losses were primarily linked to the Equity Index Puts ($5.3 billion) and CDS contracts ($2.3 billion-most of which related to high yield index).  These contracts are liabilities.  The price or cost to transfer the liability to another party is a financial liabilities Fair Value.  The contract’s value is calculated at the end of each reporting period and is done under the assumption that it is either settled or otherwise disposed.  When these derivative liabilities decline changes will only show up in the balance sheet as a decline in derivative liabilities and as an increase in equity via Accumulated Other Comprehensive Income.  They will not show up in the income statement.

 

That’s my rough take on the situation, but I may very well be wrong.  For my own calculations I try to restate the accounting so that it’s as simple as possible, but ultimately makes economic sense from an owners perspective. Better to be roughly right.

 

 

[SharperDingaan]

 

Look at the FASB classifications 'held for trading', and 'held for hedging'; then step back.

 

Most money-centre banks hold their Derivatives/CMO's etc. in the 'held for trading' bucket - which requires them to MTM and immediately book the unrealized MTM gain/loss through income. The mark was at the most recent trading price (liquidation value) & the lower the valuation the greater the adverse hit to income. If the mark is low enough there may also be an impairment hit. Volatile income & tier 2 capital.

 

WEBs Derivatives/CMO's etc. are not intended for trading, & are in the 'held for hedging' bucket - which means the MTM goes direct to equity & is offset with the MTM on an opposing asset/liability. No P&L impact & a much smaller 'net' impact on equity. Minimal volatility, no tier 2 capital consideration (as BRK not a bank)

 

The market is seeing all Derivatives/CMO holdings through the money-centre bank lens, & is penalizing everyone for the income volatility - BRK included. But .... as BRK's holdings are in a different bucket (& accounted for differently), Mr Market is mistakenly offering you BRK at a sale price. Classic WEB ?

 

You might reasonably expect the MTM 'ammendments' to boost BRK's price, but expect the 'boost' to be temporary. These 'ammendments' are being resisted in many quarters & may well only end up being applied to US flagged companies; foreign buyers of US equity taking a discount for the sub-standard accounting.

 

SD

 

 

 

[mpauls]

I think you might reconsider your critique. 

[mpauls]

e.g. ("(f) Derivatives

 

Derivative contracts are carried at estimated fair value and are classified as assets or liabilities in the accompanying

Consolidated Balance Sheets. Such balances reflect reductions permitted under master netting agreements with

counterparties. The changes in fair value of derivative contracts that do not qualify as hedging instruments for

financial reporting purposes are included in the Consolidated Statements of Earnings as derivative gains/losses.")

 

-page 32, BH 2008 Annual-

[SharperDingaan]

 

mpauls:

 

Thanks for the reference, as we're not that familiar with BRK's financials

 

Comment still stands though.

 

The gain/loss on the trading portion of the derivative net book is going through income as we've suggested. The changes in fair value of derivative contracts that DO NOT qualify as hedging instruments for financial reporting purposes are included in the Consolidated Statements of Earnings as derivative gains/losses

 

The gain/loss on the hedging portion of the derivative net book is going direct to equity as we've suggested. The changes in fair value of derivative contracts that DO not qualify as hedging instruments.

 

Given BRK's transparency, it's probably possible to get a rough idea as to the % of the net derivative book that has been nominated as 'for trading'. The lower it is, the greater Mr Markets 'miss-match' will be.

 

Happy hunting

 

SD 

 

 

[mpauls]

I'm not sure I follow the whole of your comments.  Though, you're correct that derivatives classified as hedges don't go through earnings rather AOCI, but these very small with respect their total derivatives book.