Streetwise Professor

November 21, 2008

Well, Well, Well

Filed under: Derivatives,Economics — The Professor @ 3:08 pm

Yesterday I made a snarky comment about Warren Buffet, and the fact that CDS spreads on Berkshire-Hathaway have blown out. The stock price of B-H has also tanked too.

Buffet, of course, turned the phrase that every lazy derivatives critic has used to make cheap points: “Weapons of financial mass destruction.” Buffet made this comment after one of his companies suffered big losses on derivatives trades.

The cynic in me (or should I say, “me, the cynic”–paging Lily Tomlin again) has always harbored a suspicion that Buffet’s reasoning was “I’m really smart, and of course it can’t be my fault that these derivatives were a bad bet–so it must be the derivatives’ fault, not mine.”

Well, apparently Buffet doesn’t believe his own diagnosis: Berkshire-Hathaway has lost large sums by shorting equity index puts. Whoops. Actually, double whoops. Sure, B-H collected the premium, but it was all downhill from there as (a) the decline in stock prices, and (b) the big spike in volatility both drove up the value of index puts–and hence caused the seller (B-H) to lose money. There are now some murky issues relating to collateral and Goldman Sachs that are raising doubts about B-H.

This is the financial equivalent of Jimmy Swaggert or Elmer Gantry–the moralistic crusader revealed to have committed the sins against which he had famously railed.

Not that I consider selling puts a sin–as a consenting adult, you pays your money, you takes your chances just like anybody else. Just don’t come whinging to me or the world or the regulators or whomever when it doesn’t break your way. In other words, take it like a man, Warren.

B-H is an insurance company, and by selling puts it allowed others to insure against stock price declines and volatility increases. That’s a good thing. Sometimes insurance companies collect premia, and pay off much more than they expected–that’s the nature of the business.

The key difference here is that the typical insurance model is to manage diversifiable risks (e.g., fires, car accidents) through pooling. But stock indexes are not diversifiable risks; they are systematic ones, almost by definition. They don’t go away by pooling. AIG essentially made the same mistake; its huge CDS position on CDOs imposed substantial systematic risk on the firm. Thus, both B-H’s and AIG’s strategies diverged from the insurance model.

It will be interesting to see Buffet’s explanation for this strategic choice.

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