Jon Markman: Buffett in Trouble?

I’m not so sure I believe the wild speculation part of this (last para), but I know Jon Markman, and he is a thoughtful and sober guy.

He writes:

Shares of Warren Buffett’s insurance holding company are on the ropes this month, plunging 30% in part because the famed investor dabbled in an area of the market he has long publicly derided: derivatives. And due to a tangled web of financial relationships, they may be taking Goldman Sachs shares down with them.

Investors are concerned about a $37-billion bet that Buffett made last year that U.S. and world equity values would be higher in 15 to 20 years than they were then, when the Dow Jones Industrials were trading around 13,000. Through his firm, Berkshire Hathaway, Buffett sold option contracts, known as “naked puts” to an undisclosed group of investors for around $4.85 billion, reportedly using Goldman as broker.

The buyers saw the puts as a type of insurance that would pay off royally if stocks fell over the next decade. They were seen by Buffett as an easy way to pocket a quick $4 billion-plus, which was booked much like an insurance premium, even though he is famous for scoffing at derivatives as “weapons of mass financial destruction.”

But easy money is the worst kind. The problem is that stocks worldwide have gone downhill in a hurry, and with a lot of the sort of volatility that makes put contracts swell in value. And due to accounting rules, this has made Buffett already need to mark down a $6.7 billion loss on the trade even though the trade has another 14 years to work out.

Because of its solid-gold credit rating, Berkshire Hathaway was not required to put up collateral to make this trade. But now rumors are flying on Wall Street that the owners of the contracts have demanded that broker Goldman Sachs put up collateral for the rest of the amount due. Since the value of the trade could be enormous, the collateral demands are said to be very large, and fears that Goldman will struggle to make good on its obligation has panicked shareholders.

Indeed one theory making the rounds this week is that Buffett put $5 billion into Goldman at around $125 per share in September not as an investment but to help provide funds for the collateral.

It is interesting nonetheless . .

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Source:
Buffett’s huge derivatives bet proves costly
Jon Markman
MSN, Nov 20 2008, 12:48 PM
http://blogs.moneycentral.msn.com/topstocks/archive/2008/11/20/buffett-s-huge-derivatives-bet-proves-costly.aspx