Prof. Jayanth R. Varma's Financial Markets Blog

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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     4 comments     permanent link


basant maheshwari wrote on Sun, 16 Mar 2008 11:00

Re: Is Warren Buffet's Berkshire Hathaway a hedge fund?

While your argument of evolving decisions with changing times is perfectly understandable Buffet's statement of derivatives as weapons of mass destruction was targetted more at people who used these to speculate rather then as hedging tools. In LTCM's case the firm was leveraged more then 20 times and was also hit by illiquidity but Buffett who has over US$100bn invested in a nation whose economic solvency is at stake has to do something to protect himself and his shareholders. Derivatives by themselves are excellent tools that provide liquidity and a perfect hedging mechanism to the market and its participants.The problem arises when people try and make money from naked derivative positions with more leverage and less margin. As Keynes said "Markets can be irrational longer then you can stay solvent". But surely as you have indicated this is a big step away from what Buffett professed a few years back. A very piquant observation indeed.

rohit wrote on Sun, 04 May 2008 09:26

Re: Is Warren Buffet's Berkshire Hathaway a hedge fund?

Hi prof

you mention about the puts written by buffett as speculative in nature and hence the company seems to be more like a hedge fund. i however think these puts more like insurance policy written on a low probability event. these are long dated puts (9-19 years) on major indices. although the strike price is not know, we can assume that warren buffett would have written these puts intelligently.

so the company is recieving a premium ..similar to float which they can invest. 9-19 years down the road there is high probability that these puts may expire worthless ..if they dont then the company could acutally use the puts to accquire the indices at the low valuations then.

i have read somewhere that buffett has written puts on coca-cola and used those puts to accquire the stock and thus was able reduce his cost basis. these puts could be similar.

the accounting impact could be ugly in the interim, but i dont think they are speculative

regards rohit