Warren Buffett’s playbook and derivatives deals

Here’s a look at part of Warren Buffett’s ‘playbook’ of investment strategies that he has experimented with.

Historically, Buffett has dabbled in:

  • Ben Graham’s “cigar butt” style of investing
  • Ben Graham’s workout situations: merger arbitrage, tender offers, etc.
  • Wonderful businesses at a fair price (TV stations, newspapers, companies with excellent managers, etc.)
  • Float from insurance or Blue Chip Stamps
  • Buying private businesses
  • Buying businesses out of bankruptcy
  • Buying commodity businesses at the bottom of an economic cycle (e.g. Cliffs Natural Resources)
  • Trading commodity futures
  • Preferred share deals with financial companies that have gotten themselves into trouble
  • Deals with companies trying to avoid hostile LBOs
  • Selling derivatives
  • Hoarding physical silver.  (This didn’t work out.)
  • Short selling individual stocks.  (Buffett has basically said that this is a terrible way of trying to make money.)
  • Going more than 100% long and shorting a diversified basket of stocks as a hedge.  (I believe Buffett has said that the risk/reward of doing this isn’t statistically superior to going 100% long.)

I find it incredible that Buffett is well-versed in so many things and has gone well beyond what he had learned from Ben Graham (and Phil Fischer).  This blog post will look at just one segment of Buffett’s playbook: derivatives.

On this blog, I previously mentioned that Doug Dachille did an excellent lecture “Analysis of Buffett’s love-hate relationship with derivatives“.  Please go see it if you haven’t already.

Example equity put option deal

There is a 2008 Lehman Brothers presentation that leaked onto the Internet (PDF) that I discovered from this Bloomberg article.  Two of the slides contain details of a derivative deal with Berkshire Hathaway.  Here is the slide that summarizes the deal:

lehman-brothers-berskhire-equity-put

Here’s why I think this deal is brilliant for Berkshire Hathaway.

Let’s look at the worst case scenario.  Suppose Berkshire loses US$1 billion.  It received $205M upfront.  In effect, Berkshire “issued” a 20-year bond at an interest rate of 8.25%.  That’s not so bad.  For Berkshire to lose US$1 billion, one of the three indices would have to go t0 0.  (Or one of the three would have to approach 0, with some currency losses making up the difference.)  This worst case scenario is virtually impossible as it is unlikely that an index will approach 0 in 20 years.  A more realistic Depression era-esque scenario won’t be as bad as I make it out to be.

The best case scenario is that Berkshire doesn’t pay anything and makes $205M.  There is some minor opportunity cost as these derivative deals will tie up some capital (and/or affect Berkshire’s credit rating).

Overall, it is highly likely that the best case scenario will play out and that Berkshire will make an easy $205M.  It is like Berkshire issued unsecured debt with a negative interest rate.  I think it’s obvious that the equity put options are a wonderful deal for Berkshire.  And for obvious reasons, Buffett does not want others copying the trade and has been pretty tight-lipped about Berkshire’s derivatives.  I wouldn’t underestimate Buffett’s brilliance.  (Then again, I don’t own any Berkshire shares…)

Derivatives are “weapons of mass destruction”

This deal is a perfect example of why derivatives are problematic.  When the deal was struck, Lehman immediately marked the derivative to its model and recognized a “profit” of $16.5M.  Later on, the current MTM of $380.5M implies a “profit” of $175.5M.  In my opinion, these profits are largely an illusion and will not materialize.

After flipping through the presentation, I’m not surprised that Lehman Brothers went bankrupt.

Links (this section added 5/4/2014)

Berkshire Hathaway’s 2008 shareholder letter explains it better than I do.  The discussion about the equity put option derivatives starts on page 18.

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11 thoughts on “Warren Buffett’s playbook and derivatives deals

  1. Great post. “Trade is not subject to CSA and Lehman cannot request margin from Berkshire..” I think that’s the key, making it similar to insurance float. I believe he mentioned he would never have done any derivative deals if he has to put up margin. Though Berkshire’s credit rating may have taken a slight hit. We mortals don’t get to do this sort of deal without getting margin calls during the financial crisis.

  2. By the way, he wasn’t exactly tight-lipped about the derivative. He pointed out his short worst basket put thesis: the short-term nature / flaw in the Black-Scholes model in one of the annual reports with an example on 100 year European put option and how modest inflation would pretty much guarantee high index value in a century and close to zero payoff in the end. His 20 year put basket option is a shorter version of that. (Though I have to say Japan was in deflation, but Nikkei 225 were cheap to begin with before the whole Abenomics money printing.)

  3. I would add distressed debt investing / lending money to (pseudo?) industrial companies so they can stay out of bankruptcy to the list.

    In the early 2000s Buffett purchased a lot of high yield debt at a deep discount — though this was in the secondary, open market.

    The deal where Buffett and Lehman lent money to Williams (RMT as I recall) to help it prevent bankruptcy when everyone fled the sector just after Enron went under, comes to mind here. I seem to recall it was a ~ 1 year loan, 2 handed with only BRK and LEH involved. Cash cost of 15 – 20 % on the loan plus some other sorts of kickers so that the 2 lenders earned well over 30% annualized for the loan. In some sense Constellation in September / Q4 2008 was a hybrid of the above, financial company investments during the crunch, and a typical buyout.

    I mention this as distressed lending / rescue finance is a classic value investing discipline, even when done outside the bankruptcy court. On top of this, Constellation (and Williams) had major derivatives operations — as did LTCM, which Buffett was interested in buying though preoccupied with vacationing in Alaska with Bill Gates.

    Btw, you could also include the Squarz convertible that BRK issued years back– it received a lot of press because it had a negative yield on it. I seem to think that both for the Squarz and the more recent euro put options, Munger said something along the lines of Buffett had his reasons, but on balance the deals weren’t what Munger would have done. In the case of the latter I think Munger mentioned the loss of the AAA rating that they both were proud of, used in advertisements, etc. In the former I think Munger just said something along the lines of, when markets are overpriced he thinks Buffett should leave the office early and hit the bars, but Buffett doesn’t drink– so occasionally Buffett will find some intricate arrangement like the Squarz that seems perfect, though Charlie isn’t too keen on the complicated nature of the instrument and thinks it’s better off to pass on doing such things.

    • Great comment! Yes I have forgotten about those things.

      I think the Squarz deal was very small. It was more cute than anything else and a subtle hint that Berkshire shares were a little pricey.

      2- Maybe doing the derivative deals were worth it even though Berkshire would later lose its AAA rating??? The derivative deals seem unusually good. However, I don’t know how to value the AAA rating when everybody is panicking.

  4. Wow, when you list all his activities you realize how smart he is and how big his toolbox is. I’ll add:

    1. Levered bonds – Obviously through float and also he hinted at buying off the run treasuries and shorting on the run using repos

    2. Activist small cap investing

    3. Fund of funds

    4. Consumer finance – Clayton, furniture leasing, ResCap, and he was basically trying to structure and ABS CDO after the financial crisis.

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