And I beheld when he had opened the sixth seal, and, lo, there was a great earthquake; and the sun became black as sackcloth of hair, and the moon became as blood;
And the stars of heaven fell unto the earth, even as a fig tree casteth her untimely figs, when she is shaken of a mighty wind.
And the heaven departed as a scroll when it is rolled together; and every mountain and island were moved out of their places.
And the kings of the earth, and the great men, and the rich men, and the chief captains, and the mighty men, and every bondman, and every free man, hid themselves in the dens and in the rocks of the mountains;
And said to the mountains and rocks, Fall on us, and hide us from the face of him that sitteth on the throne, and from the wrath of the Lamb:
For the great day of his wrath is come; and who shall be able to stand?
~Revelation, Chapter 6
Felix Salmon asks the unthinkable: will Berkshire Hathaway lose its credit rating? Yes, that's right: Berkshire Hathaway, the Warren Buffet money machine, is in danger of being downgraded from AAA. Surely, the hour of financial apocalypse is at hand:
Berkshire's market capitalization, at $139 billion, is still significantly higher than its book value, which was $118 billion as of June 30 and is surely significantly lower now, given the degree to which Buffett's investments in the likes of Goldman Sachs have eroded. In other words, the stock market is still pricing in growth and profits, even as the bond market is much more pessimistic.
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.
A lot of wonks, undoubtedly ably abetted by NPR, have focused on the CDS market as the source, rather than the sign, of problems. But the CDS market has not, as far as I can tell, caused many problems in and of itself. AIG's problem wasn't some tricky issue with the CDS market; it was a ratings downgrade that forced them to put up more reserves. Berkshire Hathaway faces the same potential issue.
To be sure, the regulatory arbitrage in the CDS market has allowed firms to essentially write insurance with inadequate reserves, which is a problem that should be corrected. On the other hand, insurance companies do fail when their portfolios crash, even with "adequate" reserves. RIght now previously safe-as-houses securities have suddenly become, well, as risky as houses. And when that happens, the government ends up covering the loss, whether we describe it as bond insurance or a CDS.
But what we haven't seen, until now, as far as I can tell, is the kind of problems we've had in the CDO market, where contagion from massive changes in risk appetite seems able to bring down entirely solvent investors. What Salmon's post suggests is that this is changing; that worries about Berkshire Hathaway's credit rating are, to coin a phrase, being the change we don't desire.
"AIG's problem wasn't some tricky issue with the CDS market; it was a ratings downgrade that forced them to put up more reserves."
And why didn't they have the money to put up those reserves? Because they had to pay out so much cash from the collapsing CDS market. Aren't you an economist!?!?
If I were short Berkshire Hathaway, I would welcome the current and foolish Credit Default Swap panic concerning this company's ability to pay on its bonds.
My only regret now is to not have more free cash with which to buy as many shares as possible at this silly price.
At its core Berkshire Hathaway is simply a glorified insurance company - yep, GEICO on top of other paper under more paper. Sure they've got a cute chameleon + cave men and a clever marketing team but IMO behind the curtains it's really no more a house of cards than any other of the other insurance +/- derivative related institutions that have failed this year.
Why is it that you don't think that ALL of the negative trends of the markets since election day can't be attributed to what they expect The One to do come January 20th.
If that's the case, wouldn't Buffet be getting his just deserts, since he endorsed The One?
omg...people diving information from the cds market is about as reliable as divining information from the oil futures market at $145.
That bible verse, what page of Chapter 6 of Relevation is it on?
I really hope BH doesn't get hit with a downgrade that forces it to put up more collateral, which forces it to liquidate depressed assets, which causes it to fail or lose significant share value.
Because if that happens, I will not be able to stop laughing :-)
To be sure, the regulatory arbitrage in the CDS market has allowed firms to essentially write insurance with inadequate reserves, which is a problem that should be corrected.
What would you suggest as a "correction"? I am eager to hear this. I have a suspicion it involves the "r" word, which brings your bona fides into question. I doubt your commenters will be pleased with any answer that is not derived from Atlas Shrugged.
jwh has a great point. This is all Obama's fault. Historians all agree that his presidency has been a failure.
So give me a break ... it is beyond ludicrous that nobody in the esteemed illuminati MSM has connected the stock market activity, or lack thereof, to Obama. It happened at such a pristinely "coincidental" time, if it was in fact ALL Bush's fault. Right after the election, what are the chances???
You seem to be living at the intersection of Obama and trenchant.
Megan, how many billions has the US pumped into AIG so far? [that's an answerable question.] Where did that money go? [no one's talking.]
Isn't it possible that one reason the CDS market is holding up is the hundreds of billions that the US is pouring in, allowing trades to unwind?
Jeeze, Megan. Could you please justify your claim that the problem with AIG wasn't the CDSs they wrote?
Are you saying that the CDOs that they wrote CDSs aren't in dramatic danger of default?
Once again the market is subject to the unknown and in today's market that amounts to hyper-volatility. In this case the unknowns include what arrangements Buffett has made that are contingent on BH's credit rating. My reading of the structures suggests that these swaps have maturities in 2009 through 2013 with average terms of ~33mos. BH's cash reserves may be helpful here ($33Bil) as, like AIG, their insurance float is tied up in other, illiquid, heavily regulated, and thus presumably less risky investments (for what THAT's worth).
To Megan's point, a major issue, (if I got this right) is that the market for valuing CDOs was wiped out by a direct counterparty solvency fear. That market for CDS still exists but the conditions of holding them are so contingent upon ratings that when this solvency fear affects the ratings the effect is the same.
Essentially this fear forces a run on assets.
If Buffett is confidant in all that he has done, now would be an excellent time for him to repurchase shares of BH on the open market.
Or will BH be subject to Keynes' aphorism?
The market can stay irrational longer than you can stay solvent.
But the CDS market has not, as far as I can tell, caused many problems in and of itself.
Actually this isn't true. There's been a vicious cycle of a combination of CDS spreads blowing out and equity price declines, which have precipitated rating agency downgrades. As Felix noted, the credit downgrade then triggers contractually obligated collateral posting, which puts the credit in further jeopardy because of liquidity issues.
A large problem is the rating agencies have basically absconded their responsibility of opining on balance sheet strength and interest coverage in favor of letting market forces dictate their ratings. I think most observers could point to significant periods of short-term irrationality over the past 18 months.
IIRC, Moody's had a conference call the week before Lehman failed and essentially said that it didn't matter how much capital or liquidity the company had, if they didn't find a strategic (as opposed to financial) buyer by the end of the weekend, they were going to be downgraded. This was the equivalent of Michael Correleone kissing Fredo.
Is it possible to take a CDS out on the American Government's many loans?
"given the degree to which Buffett's investments in the likes of Goldman Sachs have eroded."
To what degree has his investment in Goldman 'eroded'? Yeah, the common stock has dropped to half the strike price on Buffett's warrants, but he's still getting 10% annual interest on his preferred investment; the warrants were just the frosting on top.
"At its core Berkshire Hathaway is simply a glorified insurance company..."
It owns a few insurance companies, but also a portfolio of publicly traded stocks and dozens of wholly-owned operating companies -- everything from See's Candies to the Israeli metal working company Iscar. One challenge it has is that many of its businesses are housing related (e.g., the sheet rock company USG, the privately-held carpet company, the Nebraska furniture business, etc.). And some businesses that aren't -- e.g., Moody's, American Express, etc. -- have also been hammered by the credit crunch. Still, I'd be surprised if it lost its triple-A rating. If it did, what triple-A companies would be left? I can't imagine Berkshire would lose it and not GE. That would leave what, ADP, Exxon, and Toyota?
1. Could Buffett be required to post collateral?
From the 10Q: "However, Berkshire is not required to post collateral with respect to most of its credit default and equity index put option contracts and at September 30, 2008 and December 31, 2007, Berkshire had posted no collateral with counterparties as security on these contracts."
One could quibble about what "most" means but the CDS's have a notional value of only $7 billion "market" value. With a book value of over $100 billion, Berkshire could easily post collateral on whichever CDS's in its portfolio.
Buffett has stated elsewhere that there are NO collateral requirements on the index puts.
2. Does Berkshire *Need* a AAA rating?
Frankly, no. They do not need to borrow money to finance their business. They have significant except capital in their Insurance Subs. They are structured so they would be able to maintain the highest ratings on the insurance subs. They are dedicated legal entities and rating is only concerned with claim paying ability. Most property casualty insurance is written based on significantly lower ratings. For example, Munich Re is rated by S&P as AA-.
3. The idea that Berkshire could get into a downward spiral based on a ratings downgrade isn't realistic. The first reason, to repeat again, the subs, including the Muni Bond Reinsurer is a separate insurance legal entity and has dedicated capital and can support a AAA on a stand alone basis.
The second is that they finance all their material activities with internally generated capital.
People tend to want to equate all financial businesses. They continue to fail to realize that in Property/Casualty Insurance, premiums are collected in advance. The unthinkable thought is unrealistic.
Those poor misguided fools at NPR, trying to help the average American understand why the financial system appears to be falling down around us. I would think the definition of a "wonk" would be someone who uses something besides an NPR podcast to formulate their positions.
Maybe the rapture hasn't begun quite yet. Buffet's defense here.