Monday, May 18, 2009

Buffett's restructured derivative bet

Buffett's $37 billion derivative bet on the market now pays off if stocks bounce 15% over the next decade instead of 70% over the next 18 years. According to Becky Quick, Buffet told her that changing the terms didn't cost him a penny.

According to the NY Post it did:

In recent weeks the chatter along the derivatives "rat line" has been full of rumors about the new Berkshire trades. According to traders active in the options pit, when Berkshire sought to restructure its bets (essentially buying back the multi-decade options it was short and selling new, shorter-duration options that are closer to current stock price levels) it could do so only by paying a heavy cost, since the original positions were so deep in the red.

According to these sources, this restructuring was accomplished on a "dollar neutral" basis, meaning that Berkshire didn't have to pony up cash to do the trade.

Like a gambler doubling down on credit, Berkshire instead purportedly sold a significantly larger number of short-dated contracts than the original transaction -- meaning that the potential risk of loss to Buffet and his shareholders over the next 10 years has actually increased, but only if the markets were to decline from current levels and remain there.

Sources also say that Berkshire was squeezed more on the pricing this time around since the company's credit is not quite as pristine as it was two years ago.

Whatever the story, it looks like the pricing for Armageddon insurance has moved materially lower.