One small change in the law could make Warren Buffett's billion dollar bet on global equity markets look less like a winner.
Buffett's Berkshire Hathaway has sold billions in options since 2004, betting that stock markets would rise over 15 or even 20 years.
But a new law requiring most derivatives users to post collateral on trades could diminish potential gains to the point where Buffett could lose interest in keeping his bet. Options prices have been rising amid concern that Buffett might buy back the options he sold, traders said.
Even if rulemakers water down the financial reform law, banks may push Berkshire Hathaway to post collateral now that it no longer carries pristine triple-A credit ratings.
Berkshire Hathaway has prided itself on not putting up collateral on most of its options portfolio, even in 2008 when option values rose, triggering more than $5 billion in paper losses on the contracts he had sold.
Rising options values are likely to have triggered paper losses for Berkshire Hathaway in the second quarter as well. The insurer reports its results on Friday.
Buffett has repeatedly said he is not bothered by those paper losses, but posting collateral could be a problem. When Berkshire Hathaway sold the options, it received billions of dollars in upfront cash premiums. It can use that money as it pleases. If it had to put up collateral, it would effectively get a much lower return on that trade.
He doesn't want capital tied up in a low-return venture, which is probably what he would see it to be if he had to post full collateral, said Philip Guziec, Morningstar derivatives strategist in Chicago.
In the worst-case scenario, if markets tank and Buffett has to post collateral, he could face tens of billions of dollars if the underlying stock indexes went to zero.
That seems unlikely, but other insurance companies have been walloped by guaranteeing risks in financial markets that seemed remote.
In December 2007, American International Group executives hosted a lengthy conference call in which they repeatedly told investors that they were unlikely to suffer economic losses from credit default protection it wrote on repackaged mortgage securities.
After $182 billion of taxpayer bailouts for the insurer, it is clear that the executives were wrong.
At the end of last year, Omaha, Nebraska-based Berkshire had about $63.1 billion of derivatives exposure. Roughly 60 percent, or $38 billion, was from equity index options.
Across its equity and credit derivatives, the company said it was required to post just $35 million in collateral. Berkshire Hathaway had cash of $28 billion and total assets of $297.1 billion at the end of 2009.
Buffett famously commented in a letter to shareholders in February, 2003, that derivatives can be financial weapons of mass destruction.
Yet while the 79-year-old has always defended Berkshire's options plays to shareholders, most of these contracts were entered before lawmakers began discussing financial reform.
The financial crisis highlighted the risks of the $615-trillion over-the-counter derivatives market and it became one of the focuses of the reform.
Over-the-counter derivatives, which are contracts that are traded privately rather than on an exchange, created a web of dependence among banks and their customers, meaning that the failure of any one dealer could wreak havoc on the system.
That some players did not have to post collateral on their trades meant that a single customer's failure could cause major repercussions.
The Dodd-Frank Act signed in July forces most derivatives users to post collateral, a provision that Berkshire Hathaway lobbied against. Lawmakers agreed to exclude some users of derivatives, those deemed commercial end users, from the requirements [ID:nN01138000].
It's pretty clear (Warren Buffett is) not a commercial end user, said Sherri Venokur, a derivatives attorney in New York, adding that lawmakers intended the exemption for power companies and airlines, among others.
Berkshire Hathaway sold options to major banks including Goldman Sachs Group over multiple years, a salesman and a risk manager familiar with the transactions said.
The banks were not required to request collateral from Buffett under rules at the time and they were willing not to request it because they viewed him as a safe counterparty.
Everyone thought he was utterly, utterly riskless, said one former derivative salesman in London, who worked on one of the trades.
But that may no longer be the case. Berkshire Hathaway was downgraded one notch by ratings agencies earlier this year after it bought railway Burlington Northern Santa Fe.
Although the downgrade does not significantly increase the company's collateral requirements, counterparties may demand more protection anyway, two bankers said. Buffett was unavailable for comment.
The financial crisis and the failure of Lehman Brothers taught banks the importance of backing up trades with collateral, making them less likely to enter agreements like Buffett's in the future and more likely to call for cash on existing trades, even if new laws did not require it.
He is going to have to post collateral, the question is when, said Russell Abrams, founder of hedge fund Titan Capital Group, which trades options. Keywords:
Berkshire Hathaway has said its options reference four major equity indices; the S&P 500, the FTSE 100, the Euro Stoxx 50 and the Nikkei.
Buffett has said the contracts are known as European-style put options, meaning Berkshire would only have to make payments when the contracts expire -- and even then, only if the indices are below where they started.
The contracts are valued using a model Buffett has criticized, which estimates the riskiness of the options based on historical market fluctuations, known as volatility.
At the end of the first quarter, Berkshire had $36.76 billion at risk through these trades. For a graphic of his liabilities from the options, click on http://link.reuters.com/zyw33n
That is, if all four indices fell to zero at the contract expiration date, Berkshire would have to pay $36.76 billion. The options, entered between 2004 and 2008, had maturities of 15 or 20 years, Berkshire has said.
Those four indices dropped between 11 and 15 percent in the second quarter. Over the same period, the Chicago Board Options Exchange's VIX index, which uses one-month option prices to indicate expectations of stock market volatility, almost doubled to 34.54 from 17.59.
Option prices generally have been rising as stock market volatility has increased, but the uncertainty over how the regulation will apply to longer-dated options has caused implied volatility for those contracts to spike.
Many investors have interpreted the higher prices as a sign of pessimism about the stock market [ID:nN27108308]. But fear of Buffett unwinding his positions, or even failing to sell new options, may be a big factor, too, experts said.
If there's no one willing to sell, (the price) is going to go up, Morningstar's Guziec said.
That fear alone could force Buffett to act -- as the market value of the options rises, Berkshire Hathaway may face even more pressure to post collateral or unwind the positions.
Berkshire Hathaway has trimmed risk on the positions before. Buffett last year said that he shortened six of the contracts' maturities and lowered their strike prices -- the index level below which he would have to make payments -- between 29 and 39 percent.
At the end of 2009, the weighted average life of all the contracts was about 11.5 years, Buffett reported.
Cutting the total exposure further by reducing strikes and the length of the contracts could make sense, said Meyer Shields, an insurance analyst at Stifel Nicolaus.
I don't know that any investors that I've spoken to think that this is the best use of capital.
Shields said the typical Berkshire investor has changed since the company split its Class B shares 50-for-1 in January and joined the S&P 500.
Joining the index meant that certain institutional investors, such as pension fund managers that are required to own S&P 500 stocks, had to buy the shares.
Analysts said that with new shareholders, Buffett could face more pressure to explain the contracts, which add volatility to the company's quarterly statements.
The last couple of years we've seen that even if these deals all work out in the end, quarter to quarter they may cause a little heartburn, said Clifford Gallant, insurance analyst at Keefe, Bruyette & Woods.
There are valid reasons for people to be unhappy that these (options) are here, said Gallant. It brings an element of volatility to quarterly results that I think people don't like... It's not the reason people invest in Berkshire.
(Reporting by Elinor Comlay. Editing by Dan Wilchins and Robert MacMillan)