Nobody was laughing. It was just that for those who didn't understand very well what Warrant really mean, and as soon as they knew what it is then people stop wondering that Buffett would lose money on GS.
Buffett's thinking behind his derivatives contracts is clearly stated in plain language in his attached letter to shareholders on pages 18 through 21 inclusive (as marked on the document). Hopefully this will clear up the misinformation posted by the ET "experts."
Buffett doesn't have near the understanding of volatility that Atticus has. It is highly possible that Buffett bought the top tick of the market and that it is one of the worst trades ever. Buffett had billions of cash and got careless. The $10B unrealized loss could soon be realized if the powers that be let this do what needs to be done.7:1 speaks for itself regardless of his bankroll.
"Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it assures them government aid if trouble hits. In other words, only companies having problems that can infect the entire neighborhood â I wonât mention names â are certain to become a concern of the state (an outcome, Iâm sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply wonât do; itâs mindboggling screw-ups that are required. Considering the ruin Iâve pictured, you may wonder why Berkshire is a party to 251 derivatives contracts (other than those used for operational purposes at MidAmerican and the few left over at Gen Re). The answer is simple: I believe each contract we own was mispriced at inception, sometimes dramatically so. I both initiated these positions and monitor them, a set of responsibilities consistent with my belief that the CEO of any large financial organization must be the Chief Risk Officer as well. If we lose money on our derivatives, it will be my fault. Our derivatives dealings require our counterparties to make payments to us when contracts are initiated. Berkshire therefore always holds the money, which leaves us assuming no meaningful counterparty risk. As of yearend, the payments made to us less losses we have paid â our derivatives âfloat,â so to speak â totaled $8.1 billion. This float is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time. Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake. Only a small percentage of our contracts call for any posting of collateral when the market moves against us. Even under the chaotic conditions existing in last yearâs fourth quarter, we had to post less than 1% of our securities portfolio. (When we post collateral, we deposit it with third parties, meanwhile retaining the investment earnings on the deposited securities.) In our 2002 annual report, we warned of the lethal threat that posting requirements create, real-life illustrations of which we witnessed last year at a variety of financial institutions (and, for that matter, at Constellation Energy, which was within hours of bankruptcy when MidAmerican arrived to effect a rescue). Our contracts fall into four major categories. With apologies to those who are not fascinated by financial instruments, I will explain them in excruciating detail. ⢠We have added modestly to the âequity putâ portfolio I described in last yearâs report. Some of our contracts come due in 15 years, others in 20. We must make a payment to our counterparty at maturity if the reference index to which the put is tied is then below what it was at the inception of the contract. Neither party can elect to settle early; itâs only the price on the final day that counts. To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 â down 10% â on the day of maturity, we would pay $100 million. If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In the meantime, the sale of the put would have delivered us a premium â perhaps $100 million to $150 million â that we would be free to invest as we wish. Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24, 2028. We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future. Nonetheless, we have used Black- Scholes valuation methods to record a yearend liability of $10 billion, an amount that will change on every reporting date. The two financial items â this estimated loss of $10 billion minus the $4.9 billion in premiums we have received â"
Oh please... Fischer Black and Myron Scholes have forgotten more about options than asskiss will ever know. Buffett disagrees with how BlackâScholes values long term options and guess who has all the money? Hint: not Black, not Scholes and certainly not asskiss. You have no idea if it's a bad trade or not because the ONLY prices that matter are the four index prices on the final days of the contracts. You're also wrong that "the $10B unrealized loss could soon be realized" which further shows how little you know. First, the mark-to-market paper loss was actually $5.1 billion at the time it was reported because Berkshire received $4.9 billion in premiums. Second, the market has gone up since then. Third, "the powers that be" won't do jack squat. The terms of the contracts are that neither party can settle early and the gov't has neither the authority nor a reason to change it. Like the lilliputians who said during the tech bubble that Buffett had lost his touch, your opinions here are premature and naive.
Buffet states a 9 billion dollar liability if indices lose 25% from inception. The contracts were atm, so 1135.50 on SPX would result in a 4.1 billion net-loss at expiration. Buffett's talk of a $10B liability in the annual letter infers an SPX valuation <1135 and we're currently trading at 980. Anyone can solve for convexity at locale, and he's carrying a $delta of approx. 1.6MM per tick on SPX. He's still short a lot of convexity to arrive at a loss of 37B at 0.00 on SPX. At 970 he's carrying a liability [including the prem] of ~$11.5B if the contracts were to expire on 7/24/09. No mention of an attenuation of the liability is mentioned anywhere in the letter. No hedge.
"666" was born with microcephaly and convinces his caretakers that he can be more independent. He embarks on a trip to 7-11 for a box of twinkies and some blow-pops. He crosses against the light and is critically-injured by a city bus. His caretakers' sue the city, winning "666" 300MM on damages. After an arduous rehabilitation, "666" invests his 300MM by writing an SPX 1514 put, thereby insuring his legacy as a shrewd investor.
while you seem to be pretty accurate with your unrealized p&l evaluation you still stubbornly ignore the trade in its larger context. First of all you fail to understand everything that was said about "too-big-to fail", meaning, if world equity markets dive another 50% from here Buffet does not have to worry about his derivatives trades anymore, other investments are already of much higher priority, ignoring that the world around his company would have long broken down anyway. I bring it up because you blatently ignore that W.B. is a long term investor who has made the money he has made because he each time bought into weak markets when everyone else was panicking. You never buy the exact bottom. In this context his short put basket as well as his long GS investments are no departure from his investment style which has served him so well. Secondly, you still know very little about his other investments. You can come along with you "fiduciary duty" argument as much as you want, from your posts it becomes apparently clear you are very ignorant about the trade in its larger context. You perfectly resemble some of the very typical french index traders. They are well trained in options theory, some make consistant money, they obsess over being delta neutral and make sure it stays that way. They know their risk, they know how their risk shifts with every spot moves. They so obsess that they precisely measure how the weekend affects their deltas on and make sure to hedge to the nearest penny. They know their options book very well. However, they completely ignore the fact they are trading in a larger context. They are there to make money. I experienced that most index traders who live in such small world do not produce enough to make their seat worthwhile in a pure prop environment until the big boss steps in and puts the big delta trades on. I am not saying what they do is wrong, they actually make a good living for themselves. But the point is their returns are relatively meager (over time) vs. what is made on delta by equally well trained delta guys. You act in precisely the same way. You obsess over this option trade as if it determines life and death while it represents a tiny fraction of his notional exposure as well as it represents a tiny fraction of his monthly unrealized pl swings (it was rightly pointed out to you that this particular put unrealized pl actually is nothing he needs to worry about). Buffet is not a derivatives guy he made money by buying undervalued and unwanted paper he sees value in. This time he also made the right trade albeit with a dose of wrong timing. Argue as much as you want about unrealized losses, you are 100% correct in a sell-side or hedge fund environment. You fail to see this is not a hedge fund. Period.
I am paid to take discretionary bets, not to trade neutral. 50% of my trading is delta-bets. Your description of my trading resembles your Nikkei/Kospi replication. I trade arbitrage because it's free-money, but I don't gamma-trade, and I don't take crowded trades. The irony is that you're an index trader and I am not. I am not arguing against a "nuke event". You introduce a new tangent with every post, and you're essentially contradicting/arguing with yourself. I limited my critique to the logic behind selling ~14% vol and buying 1514 SPX, as well as Buffett's public derision of the product while he's underwriting billions in puts and CDS exposure. Do as he says, not as he does. He's on the record stating that he went into this position to add alpha. BRK's structuring is immaterial. OK, so it's a PE firm, so what? You've written a few thousand words to defend the indefensible. Buffett's counterparties can book billions by crossing this position. So who won? This is the largest marked-loss that Buffett has taken in recent years, so I'd say it's material.
you trade discretionary...and...you trade arbitrage...interesting combination...or could not decide which one to pick? Also, I never mentioned I am an index trader, while I mentioned I also trade index options. As you already seem to infer from my previous posts you should possibly read more carefully. As an aside, there are very different types of index options guys, I highly assume you know that. I dont get your spin on words. Your modality comments in one of your earlier posts also made zero sense and did not add anything to the discussion. Agree that one can only book what has expired or been offset? How he marks the trades is another story but I and others dont get why it does not get into your little head that if by expiration the cash ends above strike - prem he has nothing to worry about. His counterparties also mark their book in WHATEVER way they want (who decides where 10yrs vol is anyway) but the day when anything gets booked is far away. A second thing you really dont get at all is that he pulled 5billion out of the very pockets that kissed the street for a dime months later. Not a bad trade to turn around and dictate the precise terms of the returns he wanted for the reinvested 5bil. You are an options brain but you pathetically fail in getting outside of your little box.