Wednesday, November 19, 2008
what's wrong with berkshire hathaway?
All insurance companies have a certain amount of event risk. But for Berkshire Hathaway the event the company is most worried about isn't a hurricane or an earthquake -- it's a credit downgrade. Roger Ehrenberg asks the question on everybody's mind: "If the market continues to push against Berkshire's credit will a downgrade become a self-fulfilling prophecy?"
A downgrade could be very, very bad for Berkshire, depending on how its collateral agreements are worded. At some point, Berkshire's counterparties are going to be able to ask it to put up a lot of collateral against the derivatives contracts it has written -- not only the CDS contracts, mind, but quite possibly also the long-dated put options it's written on broad stock-market indices. Such collateral calls could be extremely harmful to Berkshire's business model -- and that's before taking into account the loss of business at its new monoline subsidiary.
when monoline insurers were revealed to be a house of cards built on little more than an impeccable rating, few hesitated to say that any such company didn't deserve such a rating. berkie (not alone among insurers) is exactly that.
despite the protestations of the acolytes of warren buffett, this relentless liquidation spiral can very definitely kill berkshire hathaway along with many other insurers.
UPDATE: felix salmon with more on berkshire.
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Fears are centered around the long-dated equity index put options it wrote beginning in 2005, on a notional amount of around $40 billion. In Warren's eyes he has secured almost $5 billion in option premium that he can use for acquisitions, stock buybacks, etc. In the market's eyes some believe Berkshire is going to have to come up with collateral for the decline in the short option position. Reality is, the only way Berkshire has to post is if its credit rating falls below a pre-determined level. As unlikely as this may seem, those in the credit derivatives markets are looking at Berkshire credit risk with a wary eye. Sentiment in this market is as volatile as the VIX: if the market continues to push against Berkshire's credit will a downgrade become a self-fulfilling prophecy?
not only is BRK/A collateral posting vulnerable to a ratings change -- so would its underwriting business, including its new monoline. and the fact that it is vulnerable to a ratings downgrade has already obviously jaundiced credit markets w/r/t BRK-A -- and if the ratings agencies follow the market, $30bn+ in cash might be very little defense given credit illiquidity and the financing requirements of any insurer.
one of the things that is a lot different about a liquidation spiral is that even good companies are killed because of what was previously thought to be responsible and manageable exposure to leverage. its symptomatic of all such periods in market history, and the failure of BRK/A would join a long list of previously unimaginable failures immanentized by a systemic delevering.
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