My friend and occasional correspondent Edward Jay Epstein here analyses Buffett's strategy, past and future. And also how the hedge funds intend to profit from what he must do.
Fueling The Fire: The Hedge Funds vs. Warren Buffet By Edward Jay Epstein
On Saturday, Warren Buffett’s holding company, Berkshire Hathaway, finally released its numbers, which showed that it had the largest decline in book value in its history. But even before this bad news was announced, hedge funds were massively shorting not Berkshire Hathaway itself but the publicly traded companies in its $50 billion portfolio. Their bet is that Buffett would be forced to dump the stock of these companies because of his holding company’s vulnerability to massive losses on derivative contracts, including credit default swaps.
It turns out that even as Buffett was denouncing derivative contracts as “time bombs” and “financial weapons of mass destruction,” he was amassing one of the world’s largest positions in them. For example, he sold derivative contracts on four stock-market indexes—the S&P 500 in America, the FTSE 100 in the U.K., the Dow Jones Euro Stats 50 index in Europe, and the Nikkei 225 Stock Average in Japan—for $4.9 billion, thereby exposing his company to more than $35 billion in losses. In 2008 alone, these contracts had lost nearly $10 billion on paper, and with the market in free fall in 2009 they lost another $3 billion. Indeed, each percentage point these indexes decrease adds another $350 million to the loss Berkshire Hathaway is liable for.
Buffett also sold more than $2.4 billion worth of credit default swaps—the infamous instruments that brought A.I.G. down once it lost its Triple A rating. Such contracts insure that companies will not default on their debt. In addition, Berkshire Hathaway subsidiaries sold derivative contracts on energy for “operational purposes.”
Although even the multi-billion dollar paper losses on these derivatives don’t require Berkshire Hathaway to put up money to guarantee payment to its counterparts, they weaken its balance sheet. And since Buffett prides himself on maintaining a “Gibraltar-like financial position,” the hedge funds are gambling that Buffett will protect Berkshire-Hathaway’s balance sheet—and its Triple A rating—by selling part of its portfolio. If that happens, they expect to profit in their short sales from the plummeting prices. Whether or not their play will succeed against Buffett remains to be seen.