Investment XYZ

Tuesday, May 02, 2006

Buffett's WMD

Press in last few days has noted about Warren Buffett’s recent big short positions in far-term international index put options (news). Since it is Warren Buffett, the Bloomberg reporter was talking glowingly of this trade, even mumbling something like “he will make money whether market goes up or down.” What’s a change. I wonder whether she can tell the difference of “call” and “put”, “long” and “short”.

From the press, the size of the Buffett trade is 14 billion, with duration 15 to 20 years, on 4 major indices, 3 of which are outside US. The 14 billion is the notional value, namely the maximal loss he can occur if all the indices drop to 0. However, it is not clear about the detail structure of the deal, is it a swap, or just a plain put with long duration? Who is the counterparty? Obviously it is also impossible to know what kind of implied volatility the trade is sold at.

I’m a bit baffled by this trade, but also amused by the reaction. Many people would immediately link such a massive deal with Buffett’s famous remark calling derivative as “Financial Weapons of Mass Destruction”. To be exact, his original remark was on the “OTC Derivatives”, not regarding the exchange traded derivatives. But still, this deal is obviously OTC. The longest exchange traded index options are only of 3 years in duration at most.

Buffett’s WMD remark was based on his observation that OTC derivatives 1) are complex and has hidden liabilities that may not be fully disclosed or understood; 2) Difficult to value since there is no public market for them. If his deal is in plain vanilla put with extended expiry, the first point won’t apply here. The second point is valid for this deal.

So is Buffett talking from both sides of his mouth -- on one hand chiding the investment world on the evil of OTC derivatives, while on the other hand, doing a massive deal on OTC derivative himself? Moreover, he is doing it on the short side -- the side that he would be blown up in case the WMD should went off. So what's the deal here?

If you read a little bit about Buffett, you would find that actually he is an old hand in derivatives, thus give him the talking rights for that famous WMD remarks. Remember LTCM? The press loves to talk about LTCM since the media and the public can blame anything that is hard-to-understand on it. In fact, Buffett almost did a deal to "rescue" LTCM with his own money. If the deal would had gone through, Buffett would get a tremendous good deal on all those LTCM derivative positions (and LTCM would get rescued -- but would incur big loss though saving the disgrace of being rescued by the Fed orchestrated effort). Buffett would get those huge short volatility index options at an extremely high implied vol (now look at the current deal he just doing, any similarity?), and he would get those bond arbitrage positions and risk arbitrage trades when the spread is widest (and with our 20/20 hindsight, we all know eventually those index volatilities dropped like a rock, and all those spread collapsed -- even LTCM, under the supervision of the several banks that take over their entire book, would eventually make money for their investors). Buffett is certainly not just a savvy stock investors, but a very savvy derivative investor.

Another fact: the equity investments that Buffett made his first mark was in insurance (those wacky GEICO ads should remind everyone of Buffett?) which in essence is the business of selling puts. In such perspective, this recent deal seems to be quite natural for Buffett rather than out-of-ordinary.

What baffles me about this trade is not of the fact that it is a massive OTC derivative trade, but by the timing of this trade. Why sell volatility and long delta now? The exchange market implied volatility is at a quite low level at this point, thus it can reasonably guess that Buffett's OTC put deal can't be done at a very high implied vol (the counter party that does this deal with Buffett is certainly no dumb farmer, but savvy investment bank that deals with implied volatility every day). The other similarly structured OTC derivatives, the LTCM deal (if Buffett would had got it) would had been shorted at a very high vol, thus almost certain it would be profitable, while this current deal, if shorted at the present exchange market vol, profitability would only be 50/50.

Shorting put has the magical enticement of letting you making money right away, and making money day in and day out, until one day suddenly it hits you with a hammer at the most unexpected moment. For savvy traders, they would hope to sell put when the market is panicking (while all the investors are buying puts at a sky-high premium), and cover it (buy the put back) when the market calms down (or keeping the fingers crossed to wear out the options to expiration, if it is not too far away). For Buffett, both of these two profit-locking methods won't work for him -- it is OTC derivative, thus it is very hard to buy it back, and it is very far term (15 to 20 years), so your fingers get tired trying to keep it crossed for 20 years.

In fact, it is not the question of whether this trade will be profitable or not -- it is highly likely that this trade will be profitable in the end (just like most of LTCM trades are profitable in the end). If Buffett marks his book by model (which is likely the case because there is no market for these OTC options, he has to mark to model), it is almost certain that he already has positive P/L for this trade so far. The serious question is, during the next 15 to 20 years, at the moment when market crashes (which is almost certain to happen), will he be solvent?

More of an interest rate play?

Interest rate usually is a minor factor in option valuation when comparing with volatility and other factors. However, for such a long duration, the sensitivity of the current option value to interest rate may rival to volatility. Shorting put means Buffett is long on interest rate. If interest rate rises from the current level in the next 15 years, these put would go down in value. With such long duration, 100 basis point change in the interest rate would have 3 or 4 time larger impact in value than 1 pt change in implied volatility. Another way to look at this: if there is no earnings growth in the stock market in the next 15 years, the market has to just sloth through at the rate of interest in average just to get even with the cost of money. Just such “slow” growth would make all these currently at-the-money put way out of money so that Buffett can keep all the premium with a safe distance to protect some market crash. That seems to be a pretty good trade, isn’t it?

Counter to common belief, shorting put is actually less risky than owning stock. Obviously if you short a lot of puts, it might be very risky, just as owning a lot of stocks. The most risky strategy is selling a lot of out-of-money put – sell a lot just to get enough juicy premium.

Though we don't know the detail of the structure, it seems the strike of these put are at the money. So obviously Buffett is no reckless traders selling tons of out-of-money front month put. However, the following situation is quite likely: market goes up thus these put become way out of money, thus making Buffett a lot of "mark-to-model" profits. Now Buffet take those profits and use it in some other places. At this point these out-of-money puts would become dangerous time bomb that is barely visible.

Shorting Put

History of Shorting Put is littered with dead bodies with spectacular flameout: Nick Leeson of Barings in 1995 (loss $2 billion shorting Nikkei put to wipe out the 233 years old British bank), Victor Niederhoffer shorting front month put in October 1997 (lose 150 million overnight to wipe out his own fund), both unhedged; and LTCM shorting European index volatility (presumably hedged).

Buffett is in a different league. However, now that we all know about this trade (just as we all know about his short dollar trade), when the next market downturn or crash comes, we all would wonder about how this elephant would be doing in Buffett's book.

Whether this trade is good or bad, one thing is quite high certainty: in 15 to 20 years, both Warren Buffett and Charles Munger (Berkshire Hathaway’s CEO) might be dead when the options expire. So why worry now?

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