Macaskill on Markets: How Warren washes over his derivatives cunning
Warren Buffett’s record as an investor is unparalleled and his contribution to public life important, from pushing his fellow billionaires to pledge money to charity, to calling for a more equitable US tax code.
Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks
But Buffett’s desire to be seen as cut from different cloth than his fellow investors has led him to public-image cultivation that is disingenuous at best.
The deal he closed in August to invest $5 billion in Bank of America would have been viewed as exploitation of a weakened corporate with decent long-term prospects if it had been done by a speculator such as Carl Icahn.
It featured an element of coercion, as the investment was unsolicited and Bank of America executives might have been criticized if they had turned down an offer that later became public. And Buffett made sure that he obtained much better terms than would be on offer for a regular investor.
Buffett cannot be condemned for securing the best deal possible for himself – he didn’t make $50 billion by standing in line, after all.
But in announcing the Bank of America deal he could not resist framing the trade with the folksy and not entirely plausible details that have become his hallmark. The idea came to him while he was in the bath, Buffett said, and he then called "Brian" (Moynihan, Bank of America’s chief executive) to ask for permission to proceed. All very courtly, for sure, if perhaps not exactly how the deal played out.
It was designed to square with Buffett’s persona as a man of the people, albeit a hugely wealthy one, and with his provision of nuggets of information that are so specific that they support his overall image. Buffett noted in his most recent letter to shareholders that the annual rent on Berkshire Hathaway’s world headquarters is $270,212, for example. This conjures up an image of Buffett and his longstanding partner Charlie Munger putting in an honest day’s work in humble surroundings, before turning off all the lights and heading for home.
In fact Buffett has plenty of well-paid Wall Street types working for him, whether it is in his insurance and reinsurance subsidiaries, or among the staff who support his investment decisions.
Almost inevitably, members of the supporting cast come to adopt elements of Buffett’s persona, such as the aw-shucks mannerisms. One banker recalls pitching a derivatives investment to one of Buffett’s advisers, who asked her to slow down and explain the options components of the trade in the simplest manner possible. Options were too complicated for an ordinary investor at a firm like Berkshire Hathaway, he implied. This act might have been slightly more convincing had the banker not known that the Buffett staffer was at MIT at the same time as her, taking an advanced degree.
The Buffett adviser was presumably testing the banker’s understanding of options pricing and searching for a relative advantage for Berkshire Hathaway in a potential trade.
Buffett has taken a similar approach to his use of derivatives. He famously described derivatives as "financial weapons of mass destruction" in 2003 and repeated criticisms in the following years. He was slow to disclose that he was making big investments in derivatives at the same time, although he now provides details in Berkshire Hathaway’s quarterly accounts. Buffett had just over $35 billion in notional value of equity index puts outstanding at June 30, almost $5 billion of high-yield index default swaps, $16 billion of state or municipal default swaps and $3.5 billion of single-name corporate default swaps. Buffett sold the equity index options and the default swap protection, so he is not exposed to counterparty credit risk and has a limited threat of collateral calls in the event of downgrades of Berkshire Hathaway.
Berkshire is nevertheless exposed to enormous potential payouts ranging from 2018 to 2026 for the equity index puts, where he essentially bet that stock indices would not be lower than their level when the trades were put on, and out to 2054 for some of the municipal derivatives.
When the biggest equity index puts were sold, in and around 2005, it seemed unlikely that global stock indices would be lower in the decades ahead. That prospect seems much more plausible today. Berkshire estimated that it would owe $3.8 billion on the puts at 2010 year-end stock index levels and the total would be higher at current prices.
Buffett earned $4.8 billion of premiums from the puts, which he then put to work, and there is every chance that his long-term stock option bet will pay off. If it does it will be a testament to Buffett’s ability to analyse and deploy complex derivatives trades in hefty size, but it is not a regular investment by a regular guy.