While everyone else has been focusing on Berkshire Hathaway’s record quarter and what stocks they seem to like I continue to focus on their derivative position. The short equity index put option position shows up on pages 14 and 15 of the 10-Q that can be downloaded from www.berkshirehathaway.com. The following is a review and then update of a position I have been monitoring for over a year now.
Four times a year Berkshire Hathaway submits a filing with the SEC that discloses their holdings. Most Warren Buffett watchers dig in to see what current holdings have been added to along with any new stocks that have worked their way into Berkshire Hathaway’s holdings. I dig into the filings as well, but I’m looking for something a little different. I want to see what’s up with the short put trade that Berkshire Hathaway initiated back in the 2004 to 2008 time frame.
Some people may be unfamiliar with the trade I’m talking about, but may be aware that Warren Buffett called derivatives financial weapons of mass destruction in the Berkshire Hathaway 2002 annual report. Part of the commentary around this thought had to do with Long Term Capital Management and the focus was more on over the counter derivatives. However, by 2004 Berkshire Hathaway began initiating a pretty interesting over the counter equity index derivative trade. They sold puts on major market indexes.
Between 2004 and 2008 Berkshire Hathaway entered into what is referred to in annual reports as their equity put trade. The firm sold over the counter put options that will expire 15 to 20 years in the future. These positions are on four major equity indexes (S&P 500, EuroStoxx50, FTSE 100, and Nikkei 225). Also, Buffett has pointed out that these are European style options that may not be exercised until expiration.
Not a ton of information has been forthcoming about these specific positions. Buffett has noted that they are at the money put options written on those four indexes. Also, the timing was not too great as the majority of the trades were done between 2004 and 2007. A small number of trades were added in 2008.
Below is a weekly chart of the S&P 500 with different time periods highlighted to coincide with the progression of events listed below.
1. In Warren Buffett’s 2007 Shareholder Letter it was disclosed that from 2004 to 2007 Berkshire Hathaway had sold put options on equity indexes that were struck at the money. These put options had brought in $4.5 billion in premiums, were European style options, and were due to expire between 2019 and 2027.
2. In the 2008 letter it was noted that the notional value of the put options totaled $37.1 billion and were written on the four major indices that were mentioned above. Buffett also states that they have added modestly to the equity put portfolio and have now received a total of $4.9 billion for selling these puts. Due to the drop in the global equity markets the valuation of these puts is a liability of $10 billion or a mark-to-market loss of $5.1 billion.
3. In the 2009 shareholder letter Buffett discloses that the terms of about 10% of the contracts have changed. The maturities were shortened and the strike prices lowered. It appears that they rolled the strike prices down and gave up some time. However it was also noted that in these modifications no money changed hands.
4. In the 2010 shareholder letter Buffett discusses that between 2004 and 2008 they received $4.8 billion in premiums for 47 equity index put contracts. It was also disclosed that at the instigation of their counterparty in these trades eight of the contracts were unwound. They had received $647 million for selling those puts and paid $425 million to get out of those obligations. This resulted in a profit of $222 million. This also left Berkshire with 39 short equity index put contracts on their books at year end.
5. At the end of 2011 the book value of the remaining put positions was a liability of $8.5 billion. This is determined using a Black Scholes model. Buffett notes that if the options had all come due at that time the payment would have been $6.2 billion.
6. At the end of 2012 the liability based on their open short put positions had dropped from $8.5 billion to $7.5 billion. Again this is based on a Black Scholes valuation.
7. In the 10-Q filing for the third quarter of 2013 it appeared the liability for the open short put positions was down to $5.35 billion which is again based on a Black Scholes valuation. This was based on the S&P 500 at 1690.
8. In the 2013 annual report the liability based on their open short put positions had dropped to $4.66 billion based on a Black Scholes valuation. It was also noted that the aggregate intrinsic value of the equity index put option contracts was approximately $1.7 billion on December 31, 2013 down from $3.9 billion on December 31, 2012. A final statement on this position noted that the weighted average life of the contracts was about 7 years on December 31, 2013.
9. This past weekend I got a chance to look through the second quarter 10-Q and was surprised at what I came across when checking on the liability recorded with respect to the equity index put position. As mentioned in number 8 the liability was recorded at $4.66 billion as of the end of 2013. It actually ticked up a bit to $4.73 billion as of the end of the second quarter. This rise was despite the S&P 500 being up a little over 6% as of the end of the second quarter. The rise in the liability was a nice reminder that the equity index put position is not 100% weighted to the S&P 500. There are also agreements based on the EuroStoxx50, FTSE 100, and Nikkei 225. At as of June 30th the EuroStoxx50 was up 3.84%, but the FTSE 100 was down 0.08% and Nikkei 225 was down 6.93% for the year.