A few years ago, I was asked to co-author the study guide that accompanies the 3rd version of The Warren Buffett Way. While doing research for this project I came across a discussion of a handful of index put options that Berkshire Hathaway had sold between 2004 and 2008. Every year when the Berkshire Hathaway annual report comes out, I dig in to see how these trades are doing. Here’s the update as of the end of 2016.
Back in 2008, as the financial world was falling apart, the business media loved to quote Warren Buffett’s comment about derivatives from Berkshire Hathaway’s 2002 annual letter. However, that line has been taken completely out of context to fit the needs of market commentators or derivative critics. The specific line appears below –
“In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”
The same letter contained the next quote, which may be a startling to many readers.
“Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies”
That’s right, Warren Buffett is a big user of those weapons of mass destruction. The full story is much too long to put in this space, but the short version is Buffett’s comments about derivatives stemmed from Berkshire Hathaway inheriting positions through the purchase of General Re®. They had a book of derivative positions that had come along with their acquisition and his comments were a reflection on an inability to properly determine the value of many positions or the strength of the counterpart of each position. Both of these issues are unique to Over The Counter (OTC) derivatives and not the listed market. For example, if you buy an option that trades at CBOE you can find the value by using a quote machine and the counter party risk component is well managed by The Options Clearing Corporation (OCC).
So how does Berkshire Hathaway use the derivatives market? It turns out that just a couple of years after the worn-out quote from above showed up in Warren Buffett’s annual letter Berkshire Hathaway started selling put options on four broad based equity indexes (S&P 500, FTSE 100, EuroStoxx 50 and Nikkei 225). From 2004 – 2007 (note the bad timing of these trades, although they look good now) $4.5 billion in premiums were received for long dated put options that expire between 2018 and 2027. Buffett notes that premiums were paid up front and that this effectively negates the counter party risk associated with an OTC derivative trade, at least on his side of the trade. This chart shows each broad-based index mentioned as the underlying on these trades. To have a apples to apples comparison each index is adjusted to a price of 100 on December 31, 2003 through the end of 2016.
Some adjustments were made to these positions. In 2008 $400 million more of these puts were sold. Also, the terms had changed on about 10% of the contracts (shortened maturities and lower strike prices – they rolled in and down). In fact the first contracts now expire in mid-June 2018 according to the most recent annual report. Also, in 2010 at the instigation of a counterparty, a handful of the contract positions were closed out resulting in a profit of $222 million and the this also reduced the running initial income from the puts sold to around $4.2 billion.
The table below shows the running intrinsic and fair value for these short puts since the beginning of 2008 in billions of dollars. The source is Berkshire’s annual reports in which Buffett makes a point to note the intrinsic value of the options as well as the fair market value (which is the required value for accounting purposes). Note at the end of 2008 the unrealized losses for these positions was pretty substantial, but as the markets have recovered, the positions have improved dramatically.
Remember $4.2 billion in premiums were received for the open positions. The intrinsic value of these positions was $1.0 billion at the end of 2016. This means if they all expired on the last day of 2016 the net profit would have been $3.2 billion plus the $222 million already booked. However, there’s time left and the fair value using an option pricing model puts the value of these options at $2.89 billion, still a decent profit.
In the next few years several of these options will start to expire and we may learn more about the specifics behind these trades. For now, each quarterly filing by Berkshire Hathaway has me checking in on the big short equity index option trade and reporting back in this space either at year end or when market conditions warrant it.