Saturday, May 2, 2009

Berkshire Meeting - Below the Radar

The most interesting comment was the following regarding the index equity puts:
He added that the company recently restructured two of its so-called equity put contracts - agreements that give an investor the right though not the obligation to buy a bucket of stocks from Berkshire at a specified date in the future. Those contracts have emerged as a subject of some debate since the stock market's plunge last fall.

Under one of the restructurings, the S&P 500 would have to rise just 13% over the next 10 years for the put to expire worthless. Before that deal, the S&P would have had to rise 72% over 18 years to preclude Berkshire from having to make a payout.
This means, among other things, that the original puts were written at the top -- 1.72 x S&P is getting close to 1500.

More interesting is the backstory. I can only speculate, but lets start with the assumption that no cash changed hands as a result of the restructuring. This would mean that the time value of the puts is negative. Or at least the last 8 years of the puts.

In addition, it would seem like the motivation to do this must have been from the mystery buyer. I don't think Berkshire would initiate restructuring deals that would be advantageous to the counterparty. They do too many deals to go around and ask to renegotiate in a way that is economically disadvantageous to the counterparties.

What it sounds like Buffett is saying is that the strike price was negotiated significantly downwards -- from close to 1500 to below 1000. In exchange for lowering the strike price, Berkshire moved the expiration date forward by 8 years.

The only thing that comes to mind is that the counterparty must have gotten an accounting benefit for the change. The Black Scholes value would surely decrease. Perhaps they are using the derivatives as a partial hedge on, for example, annuity guarantees. If the change in expiration date aligned the derivatives with the underlying risk, maybe there was an accounting benefit.

If the counterparty is a US company, I would think there would have to be some disclosure.

It would also be interesting to know notional value of the derivatives. If they are a significant piece of the total, the Black Scholes value would decrease - falling directly to Berkshire's operating earnings.

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