In the current financial crisis turmoils, even investment guru Warren Buffett cannot escape from it. In the past 2 months, the cost of protecting against default by Warren Buffett's AAA rated Berkshire Hathaway Inc. has almost tripled in two months, the risks levels higher than companies with low credit ratings. Buffett's investments are now in doubt by the market.
The killing power of CDS cannot be underestimated. Once a certain big trading opponent goes down, it will bring the CDS market and credit market a big mess and fear and will have a multiplying effect on the CDS losses. On the day before Lehman Brothers goes bankrupt, once Wall Street's third largest investment bank Merrill Lynch was bought over by Bank of America. In the week that follows, the first and second largest investment bank Goldman Sachs and JP Morgan was slashed twice by the stock and CDS market ending up in a shaky position which then pressures the US finance department to come out with an emergency market rescue plan worth 700 billion USD.
Market Worries About Buffett's Futures Investments
CDS is something similar to an insurance contract with reference to a certain type of bond. According to the different judgment to the bond's credit rating, there is a purchase of another insurance from another party. The higher the CDS premium, it means that the risks for it is higher.
The cost to protect against Berkshire being unable to meet its debt payments, based on credit-default swaps, is more than four times that of rival insurer Travelers Companies Inc. At those levels, the swaps are typical of companies rated Baa3 by Moody's Investors Service, one level above junk.
According to CMA Datavision, Berkshire Hathaway's bonds default premium has risen from a 2 month's ago value of 140 basis points to 415 basis point which means that a 5 year 10 million USD bond premium has reached 415 basis point a year.
Berkshire Hathaway's shareholders says that this rise in premium could be related to Buffett's series of investments in the 4 global futures which includes S&P 500. Buffett sold 4.85 billion USD worth of contracts to counter the drop in the stock market. Under the agreement, if on a certain date in 2019, the market index is lower then the signed value, Berkshire Hathaway will have to pay an extra 37 billion USD. Till 30 September 2008, Berkshire Hathaway has signed 67.3 billion USD worth of contracts and at that time the S&P index has been going down for consecutively 4 quarters. Buffets did not disclose what other indexes he invested in other then S&P 500.
Shareholder: Company Will Not Loose 40 billion
For the swaps to pay off, Berkshire would have to exhaust its $33.4 billion cash hoard, and Buffett's decades-long record as the world's most successful investor would have to come to a cataclysmic end. Pabrai investment manager, also Berkshire Hathaway's shareholder Mohnish Pabrai says that the swap buyers are projecting "present circumstances into infinity'' and concluding Buffett's bet will cost the company $40 billion USD. But he said it will never happen.
"If you were going to start picking companies that are going to default, you probably wouldn't put Berkshire at the top of the list, so it's totally unexpected to see them there,'' said Jeff Matthews, Connecticut-based hedge fund Ram Partners LP. Of the swaps, he said: "I wouldn't buy them, and yet it's there.''
Standard & Poor's said Buffett's bet on the stock indexes wouldn't cause a liquidity crisis. Berkshire spokeswoman Jackie Wilson said she had passed along requests for comment to Buffett. The stock fell below $100,000 a share for the first time in two years last week and has dropped about 33 percent this year.
Short Term Fluctuations In Exchange for Bigger Gains In the Long Term
"I believe these contracts, in aggregate, will be profitable,'' Buffett said in a statement in May, reiterating comments from his letter to shareholders in February. "We are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.'' "If Berkshire isn't triple A, I'm not sure which company would be,'' Buffett said in May.
The Depository Trust & Clearing Corporation (DTCC) data shows that ending 14 November 2008, totaling 2450 of Berkshire default swaps have been sold out, insurance net worth 4.7 billion USD.
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