On Mar 24, S&P revised its outlook on Berkshire Hathaway and its core subsidiaries to negative from stable; however, it affirmed the AAA rating on all of the BRK-A companies. S&P cited concerns about marks on the derivative contracts but maintained that it would focus on Berkshire’s operating profits, which remained strong in 2008.
Rating agencies are racing to catch up with market deterioration ever since they came under heat from investors for their AAA ratings on monolines. While rating agencies took more than six months to downgrade monolines, they decided to downgrade AIG over the weekend. In both cases, rating models had failed to price derivative contracts on ABS and other structured products, forcing agencies to consider major changes to their rating systems for structured finance vehicles.
Buffett wrote 251 odd derivative contracts, including the index contract that S&P is concerned about. However, there are some key differences in the terms of these contracts as compared to those written by other insurers: First, Berkshire has written CDS contracts on 42 individual companies, 100 companies in high-yield indices, four major stock indices, and some bond insurance – All of these bets are on marketable and liquid underlying asset classes as compared to other insurers’ bets on illiquid and complex securities such as ABS-CDOs. Second, Berkshire dictates the terms of collateral calls in the event of asset quality deterioration or rating trigger – in most cases, Berkshire posts no collateral. Third, Monolines and AIG Financial products wrote cheap contracts at the peak of credit cycle fetching 8-35 bps of premium and high leverage. Berkshire, in contrast, received an upfront $4.9b or 13% premium on the equity index contracts and does not have to worry about any loss payments until at least 2019.
Berkshire has not been immune to the credit crisis with stock down 40% from peak and CDS spreads in the 300-500bps range. While Buffett has made a small share of mistakes, he has shown his acumen as a master of capital allocation during the current crisis by scooping up 10%-12% dividends over the next 5 years from GE, GS, and Swiss Re as well as free warrants. S&P is not so much concerned about Berkshire’s operating profits and statutory capital levels at this point and would revise the outlook back to stable if Berkshire’s equity investments stabilize in the next 1-2 years.
Rating agencies are racing to catch up with market deterioration ever since they came under heat from investors for their AAA ratings on monolines. While rating agencies took more than six months to downgrade monolines, they decided to downgrade AIG over the weekend. In both cases, rating models had failed to price derivative contracts on ABS and other structured products, forcing agencies to consider major changes to their rating systems for structured finance vehicles.
Buffett wrote 251 odd derivative contracts, including the index contract that S&P is concerned about. However, there are some key differences in the terms of these contracts as compared to those written by other insurers: First, Berkshire has written CDS contracts on 42 individual companies, 100 companies in high-yield indices, four major stock indices, and some bond insurance – All of these bets are on marketable and liquid underlying asset classes as compared to other insurers’ bets on illiquid and complex securities such as ABS-CDOs. Second, Berkshire dictates the terms of collateral calls in the event of asset quality deterioration or rating trigger – in most cases, Berkshire posts no collateral. Third, Monolines and AIG Financial products wrote cheap contracts at the peak of credit cycle fetching 8-35 bps of premium and high leverage. Berkshire, in contrast, received an upfront $4.9b or 13% premium on the equity index contracts and does not have to worry about any loss payments until at least 2019.
Berkshire has not been immune to the credit crisis with stock down 40% from peak and CDS spreads in the 300-500bps range. While Buffett has made a small share of mistakes, he has shown his acumen as a master of capital allocation during the current crisis by scooping up 10%-12% dividends over the next 5 years from GE, GS, and Swiss Re as well as free warrants. S&P is not so much concerned about Berkshire’s operating profits and statutory capital levels at this point and would revise the outlook back to stable if Berkshire’s equity investments stabilize in the next 1-2 years.
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