http://jeffmatthewsisnotmakingthisup.blogspot.com/2008/11/is-buffett-worried-no-but-somebody-is.html Thursday, November 20, 2008 Is Buffett Worried? No, but Somebody Is Warren Buffett professes never to worry about a position, even if itâs down 50%. Since he never strays outside his famous âcircle of competence,â except maybe for that US Air investment a few years back, Buffett figures he knows more than the market thinks it does, manic-depressive as that market tends to be. âYou use the market to serve you and not to instruct you,â he told one young investor from India at the Berkshire annual meeting this year. So the odds are good that Buffett himself is not breaking a sweat over his own stockâs 40% decline since his late September cavalry-to-the-rescue investment in Goldman Sachs. After all, who knows more about Berkshire than Warren Buffett? Still, somebody out there is indeed breaking a sweat about Berkshire, and not just the company's stock. Credit default swaps in Berkshireâinsurance against a default by Berkshireâhave been climbing ever since the market began its September swoon, and suddenly spiked in the last few days. Specifically, the Berkshire 5-year CDS began the month of September at about 100, climbed to just over 250 a week ago, and cruised to 481.7 yesterday, according to our Bloomberg. (This means somebody was paying $481,700 annually to insure against a default on $10 million of debt for five years.) Why does this matter? Well, credit defaults swaps have been an excellent early warning indicator of trouble at nearly every financial company that now no longer exists in their previous forms. And the reason is quite simple: companies doing business with highly leveraged financials can buy credit default swaps in those financials in order to hedge the risk of a collapse. This is exactly what happened with AIG. According to the recent, excellent Wall Street Journal account of AIGâs final days, Goldman Sachs reportedly was buying credit default swaps in AIG to hedge their counterparty risk well before that firm hit the wall. So by keeping an eye on movements in credit default swaps, shareholders get a good look at where the bond market thinks the company is going. And in the case of Berkshire, the bond market is worried. Most strikingly, Triple A-rated Berkshireâs CDS are trading higher than several considerably lesser lights in the insurance realm, including Allstate (301.7), Progressive (252.3) and Odyssey Re (158.3). Which begs the question, who is buying credit default swaps in Berkshire Hathaway, and why? Taking the last question first, the most obvious reason is Berkshireâs heavy exposure to derivatives, particularly the $37 billion notional value stock market put options Buffett sold for nearly $5 billion when the world markets were substantially higher than today, and on which Berkshire has taken mark-to-market losses of nearly $2 billion already. In addition to the market index puts, there is another $11 billion in notional value worth of credit default obligations on Berkshire's books. All told, Berkshire entered the crisis with nearly $50 billion of theoretical derivative exposure. This may seem ironic, given Buffettâs early warnings against derivatives as an asset class (âticking time-bombs,â he called them five years ago), but Buffett is no shrinking violet when it comes to making money off whatever comes his way that fits in that circle of competence of his. âWe have at least 60 derivatives,â he told shareholders two years ago, âand believe me: weâll make money on all of them.â And his shareholders believed him. But somebody, now, does not. Who might that somebody be? For starters, the firms (insurance companies, most likely) who purchased those index puts from Berkshire might be getting nervous that, since the crisis has not let up, they should hedge their exposure to Berkshire. Or it might be insurance companies that have purchased reinsurance from Berkshire (Berkshire does a huge business in catastrophic reinsuranceâhurricanes and such), hedging their exposure in case the âOracle of Omahaâ suddenly loses his touch. Time will tell if Mr. Market is instructing us, or not. Jeff Matthews I Am Not Making This Up