Wednesday, November 19, 2008

Felix Salmon's Musings on Berkshire Hathaway AAA

 Felix Salmon's musings on Berkshire Hathaway reifies the blogosphere regarding this subject, but basically gets it wrong.

This is the crux of Felix's musings:
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.

I don't know where to start.  First, a downgrade would have very little effect on its operating businesses.  Secondly, most of its derivative contracts do not require posting collateral under any circumstances.  Thirdly, Berkshire's monoline subsidiary is an opportunistic venture which produces modest profits currently and is not a major business.  It is a Statutory Insurer with a dedicated balance sheet in its own Legal Entity.  Berkshire Hathaway Assurance is regulated by the State of New York, and could, if needed, support a AAA rating independent of Berkshire's corporate rating.  Finally, Berkshire does not rely on external financing for the majority of its business.  Its modest debt is either borrowed on a non recourse basis by its utility subs, or is borrowed to support the Clayton manufactured home finance business, which is neither large nor particularly important (but has been very profitable).  

Let me go through the points:

"depending on how its collateral agreements are worded"       
From the 3Q 10K:  
" However, Berkshire is not required to post collateral with respect to most of its long-dated credit default and equity index option contract liabilities."
 You could debate what "most" means, but I believe it means some of its credit default swaps and none of its equity index options.  The idea, as Felix put it, that "Berkshire's counterparties are going to be able to ask it to put up a lot of collateral" is pure conjecture.  It is highly likely that the potential collateral, under the most highly stressed scenario, would be modest in the context of  Berkshire's finances.  

From the 10Q:
 "As of September 30, 2008, BHAC had approximately $1 billion in capital and has received the highest rating available from two credit rating agencies. BHRG is pursuing opportunities to write financial guarantee insurance on municipal bonds. In its first nine months of operations, BHAC produced $315 million of written premiums. The impact of this new business on underwriting results was nominal."
 Berkshire could easily maintain the entity as AAA regardless of the ratings of other units.  Further, the premiums are earned over a number of years and the impact on current profits is "nominal."  Therefore, this has to be considered an opportunistic rather then a strategic business.  Buffett has expressed the intention to quit writing new business if/when it becomes less profitable.

Most Property Casualty Insurance and Reinsurance is written by companies with ratings significantly lower then AAA.  For example, Munich Re has an S&P rating of AA- .  The Chubb Corporation, a highly regarded primary insurer, has Senior debt is designated A by Standard and Poor’s and A2 by Moody’s.  Chubb's insurance subsidiaries are rated highly for claims paying ability, but the notion that a AAA rating is critical for successfully writing property casualty insurance is incorrect.  The ONLY insurance business that requires a AAA rating is bond insurance, which is a small potatoes for Berkshire.

Berkshire's capital of $120 billion at September 2008 supports a balance sheet of $160 billion in liabilities.  Of course, it is apples and oranges, but banks typically have capital ratios in the neighborhood of 10% of assets.  (note that traditionally, balance sheet uncertainty in banks is on the asset side, and property casualty insurers have their uncertainty on the liability side).  Nevertheless, Berkshire is very well capitalized, does not significantly rely on borrowing (except for the non recourse loans associated with utility assets), and does not rely on holding company credit ratings for its core businesses.

And all this conjecture is based on what?  An quoted price on over the counter market for CDS's that isn't regulated and does not disclose transactions in meaningful detail.  We have seen cases where companies have been in a situation where ratings downgrades triggered collateral calls which further stressed the company and resulted in lower ratings.  Perhaps that is on everyone's mind, but Berkshire's situation is similar only if one focuses on the superficial analogies and ignores facts of substance published in the companies SEC financial statements.

However, an attack by shorts could damage the company.  The only plausible ratings action would be a credit watch or negative implications, but I am not seeing any basis for a downgrade.  Anything that significantly weakens the stock price reduces the flexibility of Berkshire to do deals with stock or raise equity capital if he so desires (unlikely).  This kind of negative attention isn't good, regardless of the facts.  Facts are always complex and subtle -- conjecture can fit a simple story that is hard to shake.  

Nov 20 (Reuters) - Berkshire Hathaway Inc:

* says has 'nominal' collateral requirements that would take effect were credit rating agencies to reconsider triple-A rating - spokeswoman
* collateral requirements would total 'far below 1 percent of assets' - spokeswoman

That settles it. Most have no collateral requirements means there are only nominal collateral requirements.


David Merkel said...

Did you look at any of the prospectuses for BHFG? They are all fully and unconditionally guaranteed by BHI. There is recourse to BHI on the BHFG debt, though not on any of the other debt.

The collateral requirements even if triggered are small. The greater risk for Berky is that asset policy, which has more equities than most P&C companies, does not do well.

Some of the stuff that Ajit does in the super-cat arena probably do require the AAA, but you're right, Buffett doesn't need the AAA for most of what he does. He does lose bragging rights, though... and gets a little egg on his face.

This just shows for far the credit crisis has gone, if it is even touching Berky.

cap vandal said...

Yes.....the fact that this has even come up shows how far this has gone.

BRK's insurance subs are grossly overcapitalized with respect to premium to surplus. Probably 1 to 3, with statutory standards more like 2 to 1. A factor of 6.

Interesting, but that could drive insurance rates, since a lot of companies will have equity loss induced surplus losses and may lose capacity.

1/1 renewals are already done, so it will have to wait a quarter or two.

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