Sunday, November 1, 2009

The Berkshire - Goldman OTC derivatives connection

The following story on Berkshire Hathaway's equity derivatives fiasco has been all but forgotten. This is surprising, given the recent push for derivatives regulation. The lack of coverage on this is also surprising, given the last statement in the quote below on counterparty exposure.

The NY Times, May-2008: Berkshire said it had a $1.2 billion pre-tax unrealized loss on put options it wrote on the Standard & Poor's 500 and three foreign stock indexes.

It also reported a $490 million pre-tax unrealized loss on contracts that require payouts if some high-yield bonds default between now and 2013.

The exposure may at first seem odd given that, in his shareholder letter in 2003, Buffett called derivatives "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

But in his letter this year, Buffett said Berkshire had already been paid for its derivatives contracts, giving it cash to invest, and that "there is no counterparty risk."

That's right, Buffett's firm was shorting long-term puts on equity indices. Berkshire had no counterparty exposure on these positions because they were options sellers, but someone obviously had exposure to them. Long-dated exposure is difficult to obtain in size beyond a year in term via exchange traded options. Plus selling exchange traded options will require a great deal of margin in spite of Berkshire's strong credit. That means these trades must have been over the counter (OTC).

Buffett's hypocritical statement on "financial weapons of mass destruction" must have meant that OTC derivatives are OK as long as someone else is taking the counterparty exposure. The question is who was that counterparty. It had to be a limited number of dealers to keep the trade secret. It also has to be someone who likes to be long long-term volatility, because unwinding this option risk could be costly. One firm that stands out is Goldman. They have been known to build long option positions by transacting with their clients. And they had been willing too pay more for those options than the competition because they were willing to own the risk. It is therefore safe to assume Goldman was in fact a key Berkshire's counterparty on these trades.

Given Berkshire's excellent credit, buying puts from Buffett was a no-brainer in terms of counterparty exposure in 2007. But in the latter part of 2008, Goldman must have been getting uneasy as the puts went deep into the money and Berkshire owed Goldman a rapidly growing amount. In the environment of the time, nobody's failure was off the table.

But then came this transaction:

The WSJ, September 2008: Goldman Sachs Group Inc. said it will get a $5 billion investment from billionaire Warren Buffett's company, marking one of the biggest expressions of confidence in the financial system since the credit crisis intensified early this month.
The deal is structured in two parts, giving Berkshire a stream of cash and potential ownership of roughly 10% of Goldman. Berkshire will spend $5 billion on "perpetual" preferred shares of Goldman. These are not convertible into equity but pay a fat 10% dividend.

Berkshire also will get warrants granting it the right to buy $5 billion of Goldman common stock at $115 a share, which is 8% below the 4 p.m. closing share price Tuesday of $125.05. At Goldman's roughly $50 billion market value, based on that closing price, exercising those warrants would give Berkshire about a 10% stake in Goldman.

Goldman also will go to the public to raise at least a further $2.5 billion by selling common shares. Once it does, Berkshire's stake -- if it has exercised the warrants -- would fall to about 7%. Goldman will have the right to repurchase the preferred shares at any time for a 10% premium.

The ultimate question here is how the preferred share purchase deal was linked to the massive exposure Goldman now had to Berkshire. In a way, the $5 billion cash injection may constitute a nice "margin posting" to Goldman. Were some of the put positions extinguished as part of the deal? The mass media hasn't really connected the dots on this, and it's not clear why other than to many this is an old story. But it definitely deserves another look.

If the readers have any updates on this topic, please e-mail us at

hat tip Ed.
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