Berkshire May Be Required To Post Up To $8 Billion In Collateral

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.

Comments

[The Rogue Trader]

I thought Warren said they were "Instruments of Mass Financial Destruction"? I don't understand....

[knukles]

Yes he did.  Which reminds me of one of his buddies who famously said "Yes, we can."

[Slash]

wait did gold/silver stop trading for a bit earlier?I know it's not related to this fread, but what's with the perfect horizontal line on the chart?

http://www.kitco.com/charts/livegold.html

[knukles]

Late in the day, there is a period where none of the exchanges upon which Kitco reports are open.  And during that period, they fill in the chart with a.....line.  Between the Globex close and open...as silly as that sounds.  But true.  Deep breaths...

[Slash]

oh phew!

[knukles]

Something to do...

Tell your buddy who's long of gold that you've got a new financial advisor whose demented.  And tell your other buddy who is really not a financial advisor that your other buddy is short of gold and that he's hard of hearing so he should speak really slow and loud to him. 
And have the supposed broker tell the supposed short that Obama just expropriated all the gold like FDR in the '30's. 

Great fucking fun on a slow day. 

[tmosley]

Post a youtube of the results for maximum viewing pleasure.

[Slash]

save us PPT!

[economicmorphine]

Kitco uses Dell computers and they couldn't handle the calculations, so they just flatlined for awhile.  Seriously, good question.

[Slash]

oh it changed,

[Gordon_Gekko]

One word: Hypocrite.

That said, today's fraudulent paper money based financial system makes it almost impossible for large businesses to not get entangled with derivatives. The very system that Uncle Warren supports and is so fond of - the one that got him all his ill-gotten paper wealth - will be his undoing.

[arnoldsimage]

+1

[Turd Ferguson]

Warren: (on phone) "8 billion dollars!!!"

Voice: (on other end of call) "Yes, sir, that's what they're saying".

Becky: slobber, slobber

Warren: "But Moody's is a fine company with a clean balance sheet".

Voice: "Yes, sir, it is".

Becky: slobber, slobber, gulp, gulp

Warren: "Hold on a minute".

             To Becky: "That's not how I like it. Fondle my nuts, too! Don't forget about them!

                            And shove your thumb up my ass when I give you the signal."

Warren: (back on phone) "Get Barry and Ben on the phone. Let em know I'm pissed!"

Becky: slobber, slobber, fondle, fondle

[AccreditedEYE]

The very system that Uncle Warren supports and is so fond of - the one that got him all his ill-gotten paper wealth - will be his undoing.

Seriously. He is on the wrong side of several trades with this exposure. I'm interested to see how he dodges this... If BRKA takes a massive beating, it's proof positive that at least he believed his own BS about buying America. If, however, they come out smelling like roses....

[Arius]

it could not happen to a better guy...

[traderjoe]

The laws of physics don't apply to Warren. I've heard him reference essentially that he believes there is no chance that the puts will expire in the money. But essentially he has a Texas hedge on - used put premium to buy stocks. It could work out ... or not. 

He's become part of the machine - not the folksy-contrarian he wants everyone to think he is. On the one hand, he's bullish on the long-term track record of Amerika, and on the other he thinks there will be a dollar and/or muni train wreck. And don't forget about the succession issue.

[morph]

Yes, however look at the derivatives he holds. They are the least risk you can get. S&P500 Options. Hardly complex CDO's rated AAA but full of sub prime mortgages is it? Nor is it a bundle of naked CDS on TBTF's like BP.

What he said is taken slightly out of context. Derivatives are fine on easy to value liquid assets, but most derivatives are based on guesswork from places like Moodys!

[mephisto]

BRKa doesnt have to post collateral. When they did these OTC trades, they made it explicit. The counterparties all have BRKa CDS positions to hedge.  

Now maybe thats called cheating, hypocrisy, etc. It's definitely using your reputation to get the banks to do what you want.

Unless the Finreg act can unwrite written contracts, the Barlays article is nonsense. AFAIK, Barclays were not an original counterparty for BRKA, so maybe they don't know the structure.

[You Cant Handle...]

You obviously didn't read FinReg subsection 12, paragraph 6, item e:

"(e) Just kidding folks."

[knukles]

“There’s class warfare, all right, but it’s my class, the rich class, that’s making war, and we’re winning.”         
                              -Warren Buffet

[divide_by_zero]

Had to laugh when the dbag's name came up the other day at Blago's trial with 2 other well known dbags.

But Blagojevich held out hope Obama could convince “Bill Gates, Warren Buffett, George Soros and other big money Democratic donors” to endow the organization with up to $20 million.

“I want that organization up and running now,” he said. “I’d stay as governor…it’d be waiting for me (after I left office)–it’d be my little platform

http://illinois.statehousenewsonline.com/3449/blagojevich-paranoid-about-impeachment-feared-feds/

[Ripped Chunk]

Warren can pound sand

[quintago]

his whole model is premised upon the notion that nobody should be able to hold a gun to his head.

[unwashedmass]

oh please. let's all grow up. as the ramifications of the bill are sorted out over the next ten days, i'm sure -- absolutely 100% positive -- that certain "adaptations" in wording will be made to exempt any major player from anything that might constrict its current strategies to strip the middle class of everything down to its underwear.

please, grow up.

[Cleanclog]

Exactamundo!  Just as mark-to-market became mark-to-model to enable bank profits and fewer set asides, the collateral required for derivatives may well be just a parking of a percent of the derivatives themselves.  Not much of a "secure" piece of collateral, but just you watch.  Can't really be hurting the profiteers now can they?

[knukles]

Oh well shit, I feel better already.  No ONE player alone can strip me down to my underwear..... 
Gonna have to be more like Gangrape. 
(Huge Sigh of Relief)

[Cheeky Bastard]

If they intend to use ANY equity as collateral we can be almost sure BRK will need to overcollateralize just to discount the volatility in the securities it would post. Even if it intends to post a cash-equity hybrid; it would still need to overcollateralize. Who the hell would agree to settle for equity/hybrid collateral with 0 allowable margin of error in the pricing. Thats right; only morons. I think you can safely add another 1B to that 8B; if not more.

FYI; FLA yesterday defaulted on 3B of "dirts"; the biggest muni default in the past 30 years; and today AZ was denied access to BAC short term funding at the same time it needs to roll over 700M in obligations. Yeah; he should really be "comfortable" holding any muni related product.

[Cleanclog]

Cheeky, your FYI info is fascinating.  I just tried to quickly find via a few googles but failed. Will you help?  Would love more details.  Thanks!

[Cheeky Bastard]

http://www.minyanville.com/businessmarkets/articles/richard-suttmeier-florida-dirt-bonds-default/6/29/2010/id/28964

The above link is for FL "dirts" default.

This is for AZ.

I will need to post this article; since you dont hold the subscription to the site that wrote it:

DALLAS — After weathering one of the worst fiscal years in its history, Arizona starts the next one tomorrow without a short-term borrowing agreement.

In what has evolved into a political showdown, Treasurer Dean Martin is blaming Gov. Jan Brewer for allowing a $700 million line of credit agreement with Bank of America to lapse effective today. Also gone is the state’s ability to issue IOUs for state services, a form of internal borrowing.

“At this point right now, the state cannot borrow funds to meet cash flow needs,” Martin said. “There’s only sufficient cash for two months spending. Starting in September, the state is going to have serious cash-flow problems.”

Brewer, who faces Martin in the August Republican primary for governor, yesterday announced a new economic development strategy. No one from the governor’s office was available by press time to comment on the short-term borrowing issue.

The Republican governor failed to attend a meeting of the State Loan Commission earlier this month that was to have extended the lending agreement.

Brewer said she did not attend because she was in another meeting on SB 1070, a controversial new statute that requires local police and sheriff’s deputies to enforce immigration law.

The three-member Loan Commission includes Martin, Brewer and David Raber, director of the Department of Administration. Without Brewer, the commission could not vote on extending the agreement.

Martin wanted to end the lending agreement to force Brewer to cut spending rather than borrowing for operations.

“As a result of this meeting, I have essentially cut up the state’s credit cards,” Martin said. “The state will no longer be able to cover the checks the governor writes unless it has money in the bank. If she does, those checks will likely bounce.”

In the 2010 fiscal year ending today, the state has issued $86.5 million of Treasurer warrant notes to cover spending at an average interest rate of 0.93% and a total interest cost of $3.5 million, Martin said. The line of credit from Bank of America provided liquidity for the warrants, he said.

To cover a $1.5 billion deficit, Arizona mortgaged state buildings for $750 million through the issuance of certificates of participation in January and issued $490 million of revenue bonds backed by state lottery revenues last month.

But Martin said the proceeds of those deals will be gone when the state provides five months of payments to the public schools in a period of 60 days.

“That blows through all the cash the state raised through selling state buildings and issuing the lottery bonds,” he said.

This fiscal year was the first in Arizona’s history in which the state used outside lending to cover operating costs, Martin said.

It was also the first time since the Great Depression that the state has issued warrants.

Martin said that there is now no chance that the agreement with Bank of America or internal borrowing will be renewed.

From here:

http://www.bondbuyer.com/issues/119_373/arizona_budget-1014177-1.html

[Cleanclog]

Cheeky, thank you very much!  I really appreciate the information and you taking the time to post it.  Sorry I was called to a conference call and am just now getting back to you.

Thanks again!

[Steve Garrison]

Tyler, donno if you read these comments directly, but don't know how else

to get to you. Please ask someone smarter than me to answer in a

blog how mechanically, the HVTs at GS can hold a market within .05%

for an entire day?

[unionbroker]

They can do it because the market is just your imagination, take the red pill

[unionbroker]

They can do it because the market is just your imagination, take the red pill

[tmosley]

Deja vu.

OH SHI-

[Calculated_Risk]

a glitch in the matrix! oh nooooooo!

[Young]

Moodys, Goldman, Railways, ReInsurers... It won't be so easy now that the interest rates can't be cut any lower... Shit hold on, my "stock goes up in the long term no matter what" father just saw me write that! "Noooo dad, don't hit me with the belt with the broken buckle again!!!! Aaarghg"... Shit, now I'm bleeding all over the keyboard here. Maybe the old man was just really smart, he knew how the politicans were gonna adopt Keynes and blow the bubble SKY-HIGH! Cudos.

[Phil]

 Ben Nelson will clean this up for Warren or else he'll withhold his vote

[KOZ]

The weighted average duration of his equity derivatives exposure is 11.25 years, and the new legislation offers a moratorium of 12 years.  I do not see this as a coincidence. 

[trav7777]

I guess he better get busy scheduling more eBay auctions for lunch with him

[Gimp]

Warren the "Ponzi master extraordinaire". Buy and hold, buy and hold, buy and hold.

He has had a hell of a run. 

"Becky get busy my knob needs polishing".

[J.Caesar]

lil fat man, wid a note book in his hand (Randy Newman)

[Dismal Scientist]

The fun part will be when Obama comes for him by taxing his main holdings. All those lovely branded franchises that just chuck off cash. Can't wait...

[Grand Supercycle]

On May 4th I called the end of the March 2009 bear market rally.

The proprietary indicators I use in my technical analysis can identify trend changes before they occur.

http://stockmarket618.wordpress.com/about

[csmith]

This is a positive for the derivatives dealers (JPM, GS, etc.) because once their customers are required to post collateral, the dealers can forego buying offsetting contracts to hedge. Also drives overall derivative volumes lower and might be profoundly deflationary. Judd Gregg may be onto something.

[herry]

Certainly a lot of details like that to take into consideration. Thanks windows vps | cheap vps | cheap hosting | forex vps