Berkshire May Be Required To Post Up To $8 Billion In Collateral
Courtesy of Tyler Durden
Some bad news for Uncle Warren. In a note by Barclays’ Jay Gelb, the insurance analyst evaluates the impact of FinReg on that “other” company and concludes that as a result of Berkshire having $62 billion in notional derivative exposure, the additional collateral requirement contemplated in the current version of Financial Reform (don’t worry, the corrupt idiots in Congress will strip it before all is said and done), which amounts to 10% of notional, or 100% of option proceeds, would result in $6-8 billion in collateral posting requirements imposed on “America’s Company.” Even for Buffett, this is not purely chump change.
From Barclays:
- As a financial entity, we believe Berkshire Hathaway will be classified as a major participant and not be grandfathered for avoiding additional collateral requirements.
- Buffett said at Berkshire’s annual meeting in May 2010 that, if needed, he believes BRK could use existing investments including equities as collateral rather than cash, although it is unclear to us how much additional collateral would be required.
- Notably, derivatives used by Berkshire’s MidAmerican & Burlington Northern operations as end-user hedges appear to be exempt from clearing requirements, but would be subject to margin requirements, although non-cash collateral is permitted to be posted.
- Reiterate 2-EW rating on Berkshire Hathaway. We anticipate strong results in Manufacturing, Service, & Retail and Burlington Northern, stable results in Insurance and Utilities, and choppy investment results. Additionally, we believe headwinds to BRK’s book value growth in 2Q include anticipated mark-to-market impacts from falling equity markets, exposure to Goldman Sachs warrants, and potential mark-to-market derivative losses. Long term, we remain concerned about a lack of clarity around Warren Buffett’s succession plans because we believe he is synonymous with Berkshire Hathaway.
- BRK.B currently trades at 1.34x 1Q10 BV (2.0x tangible BV), which is below its historical median of 1.7x (historical range: 1.1-2.7x). Our $88 price target is based on 1.3x YE 2011E BV of $69. Based on our assessment of potential investment marks, our current thinking is that Berkshire’s linked-quarter book value per share could fall 1-2% in 2Q10.
Here is some backgrounf on Berkshire’s existing derivative exposure:
Berkshire Hathaway is party to approximately 250 derivative contracts with a total notional value (the nominal exposure to a derivative’s underlying securities) of $62 billion at 1Q10 and an average contract life of 11.25 years (details provided in Figure 1). These contracts generate substantial float for Berkshire of $6.3 billion as of year end 2009 since Berkshire collects premiums at the inception of the contract. Similar to insurance float, if Berkshire breaks even on the underlying contract, it has enjoyed the use of free money for years (although the company expects to perform better than breakeven). Warren Buffett considers himself the chief risk officer at Berkshire and is in charge of monitoring derivatives positions.
Berkshire Hathaway has attracted unwanted attention due to its growing derivatives exposure. The company increased its exposure to fluctuating investment valuations by selling long-dated put options on equity indexes and high yield indexes as well as credit default protection for states/municipalities and individual corporations with a total notional value of $62 billion. On a positive note, these contracts provided Berkshire with $6 bn of float for investment, the contracts cannot be settled prior to expiration, and the marks reversed to positive territory after 1Q09.
Economic risk from Berkshire’s derivatives appears manageable, in our view. This is because the equity put options are European style (only exercisable just prior to expiration), and require payment by Berkshire in about 11.25 years (on a weighted average basis) if the index price is lower than the level when the contract was written. Notably, in 2009 Berkshire reduced the strike prices and shortened the maturities of about 10% of its equity put options. That being said, Berkshire’s derivative contracts enhance its exposure to equity markets as well as to the debt service capabilities of states and municipalities in a challenging fiscal environment.
Berkshire’s derivatives contracts produce meaningful accounting swings in net income due to marking these securities to market each quarter. As a point of reference, Berkshire estimates a 30% increase in equity markets could result in about a $2-billion accounting gain in its equity put options, and a 30% decrease could result in about a $3 bn accounting loss (1.5% of shareholder’s equity). Berkshire’s cash at 1Q10 was $23 billion, which approaches Buffett’s internal minimum requirement of $20 billion.
But before you start worrying that the principle of return and risk apply equally to Berkshire know this: Warren is confident all is good. And if a systemic company begins failing, he will just buy a 20% preferred stake and get all the name chasers rushing in to prop it up.
Berkshire is exposed to economic risk from derivative contracts on credit losses from states/municipalities, high yield indices, and individual corporate bonds. The total notional value of these contracts is $25 bn. Warren Buffett “feels good” about its exposure to states/municipalities, which represents $16 billion of notional exposure.
Berkshire’s high yield credit derivatives ($5.4 billion of notional exposure) could experience losses due to significant bankruptcy activity in 2008. The potential maximum loss on these contracts is $5.4 billion (fair value for Berkshire at 1Q10 is a loss of $500 mn), although potential losses should be considered in light of premiums received at inception of $3.4 billion as of year-end 2008 and investment income generated on these premiums over the 5 year life of the contract.
Importantly, Warren Buffett expects its derivatives contracts in aggregate to deliver a profit over their lifetime, even excluding investment income earned on the $6 billion of float.
Furthermore, Berkshire’s derivatives have low counterparty risk, in our view, because the company requires cash payments at initiation of the derivatives contracts. This means Berkshire always holds the money and assumes no meaningful counterparty risk. These payments to Berkshire amounted to $6 billion at year-end 2009, and they represent Berkshire’s derivatives float.
At the end of the day, none of this matters even remotely. We are positive no matter what, Buffett will find a way to exempt himself from situation which would imply there is risk to himself or his firm.
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