It was considered one of the bigger paradoxes for years. Back in 2003, Warren Buffett famously dubbed derivatives “financial weapons of mass destruction” and yet over the next several years went ahead and entered a number of the contracts, including both equities and credit, ostensibly by selling CDS to collect monthly premiums, although not to the same degree as AIG, which infamously had to be bailed out due to massive losses on its CDS book.
The billionaire had argued that agreements he made were attractive because they gave him money up front that he could invest. Berkshire’s derivatives also differed from contracts that brought down other financial institutions during the 2008 credit crisis, because he had less onerous collateral requirements.
However, at least when it comes to CDS, after several years of Berkshire trimming its credit derivative exposure, it is now completely out, and as Bloomberg reports the Omaha billionaire "just took another step to simplify Berkshire Hathaway Inc.’s stockpile of derivatives."
The company paid $195 million in July to wind down the last contract in which Omaha, Nebraska-based Berkshire provided protection against losses on bonds, according to a regulatory filing Friday that didn’t identify the counterparty. As of June 30, the maximum risk on that credit-default agreement was about $7.8 billion."
For years, the billionaire has been winding down derivatives or letting them expire. In 2012, he struck a deal to terminate contracts linked to municipal bonds. Others tied to corporate debt expired the following year.
While not as bad as AIG, Berkshire’s derivatives have been the source of some pain. Bloomberg notes that in 2008, the SEC asked Berkshire to make “more robust disclosure” on how it valued the contracts, which the company eventually did. The following year, Moody’s Investors Service and Fitch Ratings cited derivatives when the ratings firms stripped Berkshire of its top credit grade. Changes in the values of the contracts are reflected on Berkshire’s income statement, sometimes causing wild swings in quarterly profit.
“That was a very interesting chapter for Berkshire and its shareholders,” said David Rolfe, chief investment officer at Wedgewood Partners, a Berkshire investor that oversees about $7.8 billion. “And it looks like that chapter is winding down.” Perhaps because Berkshire’s last CDS had such a long potential lifespan that it could’ve continued under the next chief executive officer, that Buffett may wondered “why even bother someone with that?” Rolfe said.
The contract covered in the July agreement was written in 2008 and related to municipal debt issues with maturities from 2019 to 2054, according to regulatory filings. Buffett didn’t respond to a request for comment outside normal business hours.
Buffett has repeatedly told shareholders to look past the fluctuations from derivatives and focus instead on the underlying earnings for Berkshire’s dozens of businesses, from railroad BNSF to ice-cream chain Dairy Queen. On Friday, the company reported that operating earnings climbed 18 percent to $4.61 billion in the second quarter, driven by gains at insurance and manufacturing businesses.
Perhaps Buffett is worried about sharp fluctuations on the securities, which are essentially a bond short. “When you have to mark these contracts to market in a downturn like 2008, it gives the appearance that Berkshire’s fortress balance sheet is weakened,” said Richard Cook at Cook & Bynum Capital Management, which oversees about $350 million including Berkshire shares. “I would prefer Buffett to have as much flexibility as possible when the tide rolls out.”
Despite exiting CDS, Buffett still has equity-linked derivative exposure, as Berkshire still has some derivatives tied to the performance of stock indexes. Potential liabilities on those agreements have narrowed in recent years as markets rallied. Liabilities on the equity index puts - which expire between June 2018 and early 2026 - stood at about $4.4 billion at the end of the second quarter, Bloomberg reports.
Some of Berkshire’s energy businesses also use derivatives to hedge fuel costs. But Buffett has been downplaying the role the contracts will play at his company when he’s no longer around. “I don’t think there’ll be much of a derivatives book” under a new CEO, he said at Berkshire’s annual shareholder meeting in 2012. “There are a few operating businesses that will have minor positions.”
And with Buffett unwinding, something must be accumulating a position. One possible suspect is Citigroup. According to a Bloomberg report on Friday, Citigroup, the U.S. bank with the most derivatives, purchased a portfolio of credit-default swaps from retreating rival Credit Suisse Group AG, two people with knowledge of the matter said.
Credit Suisse said last week it had agreed to sell the positions, which consist of about 54,000 trades, to an unidentified buyer, reducing its leverage exposure by $5 billion. The gross notional value of the portfolio is about $380 billion, said people with knowledge of the assets, who asked not to be identified because the size of the portfolio or identity of the buyer aren’t public.
Credit Suisse Chief Executive Officer Tidjane Thiam is pulling out of some securities businesses as he seeks to boost the bank’s capital ratios and rein in a culture he said took too much risk before he joined. The deal shows how some of the biggest U.S. banks are looking to gain market share in trading from the restructurings of European rivals, including Credit Suisse and Deutsche Bank AG.
In order to boost returns, Citi has been on a CDS buying spree in recent months. In 2015, the bank bought about $250 billion in notional value of credit derivatives from Deutsche Bank last year and was in talks with the German bank to buy more, Bloomberg reported in March. The New York-based firm had $2.1 trillion of notional credit derivatives, and more total derivatives than any other U.S. lender, at the end of March, according to a report from the Office of the Comptroller of the Currency.
The portfolio encompassed all the CDS the Swiss bank had in its strategic resolution unit, the part of the firm it’s winding down, while it still has some credit derivatives in the ongoing trading business. Credit Suisse wants to reduce leverage exposure at the SRU by about 70 percent over the next three years, Chief Financial Officer David Mathers said last week. That measure was $148 billion at the end of June, down from $167 billion at March 31.
As a reminder, one of the reasons why Deutsche Bank has seen its stock pressured in recent months is due to investor concerns over its derviative exposure, something we first pointed out in 2013. And while unwinding a quarter trillion in derivative is a welcome start, the German banks still has tens of trillions in residual derivative exposure left, whose breakdown is largely unknown, and which may result in another risk flare up episode in coming quarters should there be a dramatic reversal in key underlying financial metrics such as interest rates.
For now, however, what we do know is that as Berkshire is unwinding Citi is, well, winding, in a long telegraphed move. Recall that at the end of 2014 it was revealed that none other than Citigroup lawyers had insert language in the Omnibus language which allowed financial institutions to trade certain financial derivatives from subsidiaries that are insured by the Federal Deposit Insurance Corp, explicitly putting taxpayers on the hook for losses caused by these contracts.
So what explains Citi's relentless appetite to add derivative exposure on its balance sheet? Simple: because depositors, and thus taxpayers, are on the hook at the FDIC-insured entity - as the bank assured when it drafted the appropriate legislation - as they were before the 2008 financial crash and subsequent bailout.