WSJ Reporter Recommends Berkshire: What Material, Billion Dollar Risk is He Not Telling You About?

In last Saturday's Wall Street Journal, June 18, 2011,  Wall Street Journal financial columnist Dave Kansas, recommended retail investors take a look at buying Berkshire Hathaway(BRK.A).  He cited numerous reasons for the recent decline in Berkshire's stock price and why one should view Berkshire Hathaway a great buy at current levels.  However, Mr. Kansas failed to outline, for a potential investor, one of the most critical elements of risk with Berkshire, its uncollateralized, speculative positions on the equity markets and municipal bond markets, created by over-the-counter derivative contracts.

Berkshire has a $34 billion bet in the form of an equity put option that the stock market will increase in the next 10 years, from unspecified 2008 levels.  It also has a $16 billion bet, in the form of written credit default swap contracts, that certain municipalities will not fail.  This creates total speculative OTC derivative contract positions of approximately $50 billion, with a current unaudited cash balance of $38 billion, at the end of First Quarter March 31, 2011.  

Yes, these are the "Notional" amounts, meaning they will probably not lose this amount.  Losses could be potentially closer to 25% of those Notional amounts.  However, Berkshire's gains on these speculative contracts are fixed at $8 billion on the equity put position and Berkshire's potential losses on these contracts are unlimited.

In a stable market, we agree, Mr. Buffett made a "good wager". However, what happens if equity markets decline as they did in March 2009 to a DOW 6700 or significantly further?  From October 9, 2007 to March 2, 2009 the Dow dropped 52.3%, from 14,164.53 to 6,763.29.

What happens if the U.S. does default on its debt and municipalities default and there is significant fallout in the equity markets?  We all know unforeseen things happen and there is no such thing as a "sure bet."  In speculation, one is prudent and prepares for that 100-year flood, that over a decade, could occur.  This perhaps was a good wager, but clearly imprudent for Berkshire shareholders to create a material, speculative risk, non-negotiable, for a decade.

Take a look at the uncertainty reported today in the New York Times surrounding the credit default swap contracts written by unknown firms on Greece's debt.  

The Derivative Project wrote on Berkshire's speculative positions in three previous posts:

If you are considering an investment in Berkshire, one should be aware, as specified in Berkshire's 2011 First Quarter Report, ending March 31, the contracts that Berkshire has entered into "may not be unilaterally terminated or fully settled before the expiration dates and therefore the ultimate amount of cash basis gains or losses on these contracts may not be determined for many years", approximately 9.75 years.

What is Wrong with These Speculative Trades for an Investor?

Berkshire took in approximately $8 billion in premium income on the equity put contracts, that they will have the use of until the contracts mature in the next decade.  However, you,  now as an investor, must closely monitor these derivative positions and Berkshire's cash positions to ensure that in a decade they can make good on these contracts, if the market moves against them.  

Berkshire does not have to post any collateral on these speculative positions, thus they can have losses in the billions in these contracts and not reserve for the liability coming due in a decade, perhaps assuming it will turnaround in their favor.  That clearly is a very nice feature that the counter parties gave them and that Congress gave them, as specified in the Posts above.

Further, one has to question why a firm such as Berkshire would seek to make a $50 billion speculative bet, when our economy could certainly use billion dollar cash infusions in sustainable economic development that would create jobs.  Having to tie up capital in speculative positions for a decade does not create any jobs or long-term economic growth for the United States.

Were these Contracts In Berkshire Shareholders' Best Interest?

Despite Berkshire getting the $8 billion in premium income upfront from these speculative OTC derivative contracts, it has a responsibility to its shareholders to reserve for uncertainty in a decade and not tie up capital in a long-term investment that could go sour, risking a default on these speculative obligations at the end of a decade.

The Wall Street Journal failed to analyze the impact of AIG's unlimited counter party credit risk on credit default swap contracts and its impact on the financial markets  and equity markets beginning in 2007. One would assume the Wall Street Journal would begin to insist its financial reporters cover over-the-counter derivatives in their fundamental analysis.  It is certainly misleading and "light journalism" to not include OTC derivative positions in a "buy" analysis and to not disclose a material  risk in a proposed investment.

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