Thursday, March 12, 2009

Berkshire Hathaway downgraded by Fitch

What hedge fund got in the ear of Fitch, with this Hail Mary Pass?

“Fitch views this risk as unrelated to Mr. Buffett’s age, but rather Fitch’s belief that Berkshire’s record of outstanding long-term investment results and the company’s ability to identify and purchase attractive operating companies is intimately tied to Mr. Buffett,” Fitch said. Buffett is 78.

The rating agencies are now a joke. After rating sub-prime mortgages AAA, now everything is junk, and nothing is AAA.

Heck, in this environment if Exxon had another oil spill, Fitch would change it's outlook to "developing!"

Fitch is worried about Buffett's "derivative" exposure? Here's the other side of that trade!

Berkshire was paid $4.9 billion for $37 billion of put exposure-here's what that entails:

Berkshire is exposed to that number if the value of European, US and Japanese stock markets go to 0. A true doomsday scenario that, should it happen, essentially means the end of all economic activity as we know it.

So, someplace between "end of the world" and "normal economic activity" is where we end up.

Let's look closer. The question is: How much does Berkshire have to annually compound the premium received to pay off the contracts, if need be? In order to do this, some assumptions are necessary.

* I will use 17.5 years as the expiration, as it's the middle ground on the contract expiration and no further details are available.

* I have to assume equal index losses should they occur at the end of the 17.5 years as there is no details available as to the weighting of contracts in what years.

* I will also use the S&;P solely as the index the put are written in as it is the largest market by far and most likely contains the largest exposure.

Here are the necessary compounded annual rates of return necessary on the $4.9 billion in premiums received in order to pay off the bet, should the indices fall by "x" percent.

But, you say, what about the other question? What level were the indices at when the options were sold? We know the majority of them were entered into during 2007 (some in 2006 and 2008 with index levels lower than 2007). But, for the example, I'll say the S&P was at 1500 - about the high of the year.

Then how much must the S&P grow between now and 16.5 years (I use 16.5 since 1 year of the contract has elapsed) in order for Warren to avoid paying off at all? Now, it should be noted that in 2008 at lower levels, Warren added to the contracts, which in reality, would lower the necessary index returns. But let's just use the most extreme example to illustrate, all contracts written at market highs.

The S&P must grow 4.5% annually for 16.5 years from today's 727 to eclipse 1500 and allow Warren to avoid paying off. Remember, this is "worst case" index contract inception number - the actual amount is lower.

What are the odds? Well, since Berkshire officially in 1965 became Warren's, he's grown value by 20% annually and the S&P has grown 8.9% annually.

Using those numbers, the S&P in 16.5 years sits at 2968, and Warren's $4.9 billion premium has been grown to $119 billion free and clear for Berkshire shareholders. If we assume sub-performance of 50% less than the historical averages for both, the S&P sits at 1491, Warren pays off a pittance (maybe a couple million), and has grown the $4.9 billion to $25.9 billion for Berkshire.

The reality is that this is just another insurance policy for Berkshire. In the event of a dramatic event, they pay off big. Anything less, they collect premiums.

The next time someone tells you about "Berkshire's huge derivative exposure," please send them here.

Maybe Fitch needs to do some homework!

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