Who did dumb deals with Warren Buffett?

Previously, I wrote about Buffett’s brilliant derivatives deals.  He will be paid to borrow money.  The deals are structured so that Berkshire Hathaway avoids counterparty risk (people who make dumb deals have a very high chance of blowing up).  So who are the counterparties?

According to this 2010 news article, two of the counterparties are Lehman Brothers and Goldman Sachs.  Buffett knows who all of his counterparties are.  Presumably, he had somebody shop around Wall Street to figure out who would give him the best pricing on these derivatives deals.  He should know which companies were and weren’t willing to make dumb derivatives deals.  He knows that Goldman Sachs was willing to do a dumb deal with him.  So I find it incredibly interesting that he decided to invest $5B into Goldman Sachs for preferred shares and warrants.  On the preferred shares, Buffett is exposed to any other number of dumb things that Goldman Sachs may have done.  If Goldman was essentially giving him free money, it was likely that it was giving away free money to other people.

Why?  I think Buffett figured out that the financial system was horribly interdependent.  Bank failures could cause a chain reaction of other bank failures.  He probably figured this out a long time ago during the Long-Term Capital Management debacle where Wall Street had to come together to avoid disaster.  Modern derivatives only made things worse and led him to warn the public about these “weapons of mass destruction” in one of Berkshire’s shareholder letters.  He speculated that the US government would keep the equityholders in all of the major investment banks solvent.  If the US government didn’t do it, it would have a major financial meltdown on its hands as the banks would enter messy bankruptcy proceedings.

Even knowing that Goldman had taken on stupid risks, Buffett was hoping to be the beneficiary of the US government subsidizing the “too big to fail” banks.  His investment is a little perverse in my opinion but it seems to have been very profitable so far.  (*To some degree he helped keep the financial system afloat by injecting capital into it before the government bailouts arrived.  So perhaps his deals are morally defensible.)

Investing in investment banks

In general, I don’t see myself investing in investment banks.  They are too hard for me to figure out.  Buffett has special insight into investment banks because he knows which ones will and will not make dumb derivatives deals.  He probably thought that Goldman was less stupid than its peers.  His investment in Wells Fargo common stock suggests that Wells Fargo is the smartest of the bunch.  However, I do not have Buffett’s insight from dealing with the banks.  Ultimately, this is not a game that I will be good at so I will stay away.

*Disclosure:  No position in BRK.A/B, GS, BAC, or WFC.

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2 thoughts on “Who did dumb deals with Warren Buffett?

  1. GS was likely just a broker in the derivative deals. Why would GS buy long term puts on equities? The real customers likely hold leaveraged positions and can’t tolerate the mtm risk to capital. If anything these weren’t great deal for brk as they likely kept brk from being more aggressive during the crisis.

    • 1a- We know Lehman Brothers did the deal due to the presentation linked to in my earlier post on Buffett’s derivatives deals. I believe they marked to model and the traders get a bonus for the mark to model profit. The terms of the derivatives deals are rather specific and not useful for hedging. Because Berkshire doesn’t post collateral, the other side has a lot of counterparty that they have to hedge. This is why Berkshire CDS got pretty expensive. The put option is on different stock indices, whichever is lowest. I’m guessing that Buffett learned this trick from a GenRe trader (because why would he sit around thinking about equity correlations). This is to game the equity-equity correlations that people use in their models. For the put option to pay out, there has to be a major crash in the stock market. If there is a major crash, it is highly likely that the markets will be correlated as they tend to all go down at once (e.g. 08/09… all stock markets crashed together). Backwards-looking correlation data may not properly take this into account.

      1b- Buffett seems to be saying that Goldman was his counterparty.

      2a- I’m not sure if they were a mistake, though I don’t understand reinsurance that well. Suppose that Berkshire didn’t do the deals. During the 08/09 crisis, it would have had a AAA credit rating instead of AA. With that credit rating, it could write some really good reinsurance deals. Ideally, if it made a profit on its reinsurance deals, Berkshire would get paid to borrow money.

      But Berkshire was already getting paid to borrow money on the derivatives deals. So you’d have to look at the attractiveness of the derivatives deals versus reinsurance it could have written. I suspect that the derivatives are better. The derivatives were easy to understand and the risks weren’t difficult to evaluate. This is not like insurance where Buffett was worrying about terrorism before 9/11.

      2b- I suspect that the parties buying reinsurance tend to be savvier and not make deals that are pretty stupid. Whereas derivatives traders have perverse incentives and will make deals that are clearly stupid.

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