Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Is Warren Buffet’s Berkshire Hathaway a hedge fund?

reports that the market is worried about the default risk of Warren
Buffet’s Berkshire Hathaway – CDS spreads have widened
from 20 basis points in November 2007 to almost 120 basis points in
mid March 2008. I spent some time reading Buffet’s letter to
as well as Berkshire Hathaway’s annual
for 2007.

What struck me was that Berkshire Hathaway is becoming more and
more like a hedge fund than a mutual fund. The transformation has been
gradual. In his 2002 annual report, Buffet famously declared that
“derivatives are financial weapons of mass destruction, carrying
dangers that, while now latent, are potentially lethal.”. He
also wrote that “When Charlie and I finish reading the long
footnotes detailing the derivatives activities of major banks, the
only thing we understand is that we don’t understand how much risk the
institution is running.”

What a difference five years makes! In the 2007 letter, Buffet
writes that Berkshire had 94 derivatives that he managed himself (up
from 62 the previous year). Buffet does not use derivatives for
hedging – in his 2006 letter, he wrote that he buys derivatives
when he thinks they are wildly mispriced. As at the end of 2007,
Hathaway had derivatives positions with a notional value of about $50
billion. The biggest chunk of these ($35 billion notional) are written
put options on equity indices. That reminds me of LTCM which too had
written large amounts of put options on equity indices. Berkshire has
sold credit protection for $5 billion of notional value of junk bonds
– too small to remind me of the bond insurers. During the last
few years, Berkshire has speculated on a wide range of currencies,
though it has unwound most of them at a profit. That reminds me of
George Soros.

There does appear to be a big difference between the big hedge
funds and Berkshire – the absence of leverage. But, probe a
little deeper, and even this is not so obvious. A large part of
Bekshire’s investment portfolio comes out of the $59 billion
float of its huge insurance business of which $46 billion comes from
the reinsurance companies. Reinsurance is best thought of as written
put options on non traded or illiquid assets.

Berkshire today is not the simple investment company that it was a
decade ago. Today it is in the business of writing put options
(financial derivatives and reinsurance) and investing the proceeds in
stocks. What Buffet wrote about the activities of major banks in 2002
is gradually becoming true of Berkshire. Rising CDS premiums are
perhaps not so surprising.


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