Monday, November 24, 2008

Felix Salmon's Can't Let Go

I suppose it is bad form in the blogosphere to pick on a fellow blogger, but Felix Salmon can't seem to let go of the idea that something, anything must be wrong with Berkshire's accounting for long dated index puts.  A prior post asserted that really bad things could happen if Berkshire were downgraded because of collateral calls associated with index puts.  This didn't hold up to the facts, so now he is back with a "helpful" short seller who is trying to dig up more reasons that it just can't be right.

This little romp begins with the idea that Berkshire used a volatility of "about 23" in the second quarter and a volatility of "about 22" in the third.[volatility as an input to Black Scholes]  Something must be horribly wrong.  A little primary research (as opposed to relying on a helpful friend with a short position) would show that "about 23" was, in fact, 22.8.  It would have also shown that these are 4 large world indices and that foreign currency adjustments have an impact on the results.  Easily enough to account for the difference between about 22 and about 23.  You don't need a conspiracy to explain the change.

Then some conjecture about how volatility should really be 50, and all of a sudden, you have an additional $15 billion in losses.  Non cash, of course.
The VIX is now at 80, but the VIX is much more short-dated than Berkshire's equity puts. But let's say that a reasonable volatility number for Berkshire would be somewhere around 50: that would mean the value of those equity puts going up by about $7 billion, before taking into account that the S&P has fallen by a good 35% since September 30. [50??? not that the VIX is the right number, but look at the history and 50 is MUCH higher then prior periods]

Lets just revisit the facts.  The nominal value of the contracts is $39 billion.  Berkshire has booked $6 billion through 3Q 2008.  They have an average duration of about 13.5 years.

At 6%, the present value of $39 billion in 13.5 years is about $18.  The idea that the losses could easily be $15 billion would put Berkshire's liability at $21 billion.  This is $3 billion more then the present value of 4 global indices going to ZERO in 13.5 years.  They would have to be, well, NEGATIVE, to justify booking $15 billion.

In its insurance business, Berkshire tries to limit its loss exposure to any single event or deal to $5 billion.  The maximum possible loss on this deal is about $14 billion pre tax.  But the maximum probable loss is much closer to the $5 billion figure, and the most likely outcome is no loss. [in my opinion]  

What is the correct number to use for volatility?  I would say it is the expected future volatility over the next 13.5 years.  How much weight should one give to unusually high volatility during a liquidity crisis?  I'm not sure, but not much.  But since this is an estimate of future volatility -- it should be a relatively stable number.   

This is the third negative Berkshire post for Salmon over the last 5 days.  I think he should just give it up.  However, I doubt it.  

I do find it interesting that the thing that seemed to kick started this series of posts was a quote regarding Berkshire credit default swaps.  Seems like they contain some sort of rock solid predictive information about the real financial strength of a company.  However, today, in the WSJ, there is a case history of Morgan Stanley's short siege from last month.  And one of the culprits was the use and possible manipulation of credit default swaps.  Go figure.
Investigators are attempting to unravel what produced the market mayhem in mid-September, and whether Morgan Stanley swaps or shares were traded improperly. New York Attorney General Andrew Cuomo, the U.S. Attorney's office in Manhattan and the Securities and Exchange Commission are looking into whether traders manipulated markets by intentionally disseminating false rumors in order to profit on their bets. The investigations also are examining whether traders bought swaps at high prices to spark fear about Morgan Stanley's stability in order to profit on other trading positions, and whether trading involved bogus price quotes and sham trades, people familiar with the probes say.

I generally like Felix's blog. And he does qualify his comments and has made at least some effort to present a balanced case. But the blogosphere is an echo chamber, and opinion and fact are hopelessly intertwined. I just expect a little more from portfolio.com.

1 comment:

Felix said...

Not bad form at all, pick away! The great thing about the blogosphere is that there are lots of views, and people talk to and pick at each other all the time. That also means I have much less equity in being right than most journalists: I'm happy to put something out there just because it's interesting to me, and not necessarily because I believe it.