Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Sat, 15 Mar 2008

Is Warren Buffet's Berkshire Hathaway a hedge fund?

Aleablog reports that the market is worried about the default risk of Warren Buffet’s Berkshire Hathaway – CDS spreads have widened from 20 basis points in November 2007 to almost 120 basis points in mid March 2008. I spent some time reading Buffet’s letter to shareholders as well as Berkshire Hathaway’s annual report for 2007.

What struck me was that Berkshire Hathaway is becoming more and more like a hedge fund than a mutual fund. The transformation has been gradual. In his 2002 annual report, Buffet famously declared that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”. He also wrote that “When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.”

What a difference five years makes! In the 2007 letter, Buffet writes that Berkshire had 94 derivatives that he managed himself (up from 62 the previous year). Buffet does not use derivatives for hedging – in his 2006 letter, he wrote that he buys derivatives when he thinks they are wildly mispriced. As at the end of 2007, Hathaway had derivatives positions with a notional value of about $50 billion. The biggest chunk of these ($35 billion notional) are written put options on equity indices. That reminds me of LTCM which too had written large amounts of put options on equity indices. Berkshire has sold credit protection for $5 billion of notional value of junk bonds – too small to remind me of the bond insurers. During the last few years, Berkshire has speculated on a wide range of currencies, though it has unwound most of them at a profit. That reminds me of George Soros.

There does appear to be a big difference between the big hedge funds and Berkshire – the absence of leverage. But, probe a little deeper, and even this is not so obvious. A large part of Bekshire’s investment portfolio comes out of the $59 billion float of its huge insurance business of which $46 billion comes from the reinsurance companies. Reinsurance is best thought of as written put options on non traded or illiquid assets.

Berkshire today is not the simple investment company that it was a decade ago. Today it is in the business of writing put options (financial derivatives and reinsurance) and investing the proceeds in stocks. What Buffet wrote about the activities of major banks in 2002 is gradually becoming true of Berkshire. Rising CDS premiums are perhaps not so surprising.

Posted at 12:52 on Sat, 15 Mar 2008     View/Post Comments (4)     permanent link

Is this the beginning of the end of credit rating?

A report by the US President’s Working Group (PWG) on Financial Markets released on Thursday could well be the beginning of the end of credit rating. It says

Overseers should ensure that [institutional] investors (and their asset managers) develop an independent view of the risk characteristics of the instruments in their portfolios, rather than rely solely on credit ratings.


The PWG member agencies will reinforce steps taken by the CRAs through revisions to supervisory policy and regulation, including regulatory capital requirements that use ratings.

In a different context, the report also says that “U.S. authorities should encourage other supervisors of global firms to make complementary efforts to develop guidance along the same lines.”

There is therefore a serious possibility that global regulators would wean institutional investors away from the use of ratings and also reduce the regulatory role of ratings. If that were to happen, would the rating agencies survive only on the basis of retail investors relying on the ratings? I doubt that very much. Long ago when Eurobonds were bought by Belgian dentists, ratings were hardly influential. Bonds were bought on the basis of name recognition – companies like IBM, Coca Cola and Walt Disney could borrow easily because they and their products were well known.

It is true that when the rating agencies began life a century ago, they did not need a regulatory monopoly to prosper. But that was before Altman showed that creditworthiness could be easily measured using econometric models based on accounting information and before the Merton model showed that the stock price by itself provides adequate information.

Posted at 04:56 on Sat, 15 Mar 2008     View/Post Comments (3)     permanent link