By Shannon D. Harrington
Aug. 11 (Bloomberg) -- Warren Buffett’s Berkshire Hathaway Inc. had to increase payouts on credit derivatives backing junk debt as the recession forced more companies into default.
Berkshire paid about $825 million on the contracts in the second quarter and $350 million in July, compared with $675 million in the three months ended March 31, the company said in a regulatory filing last week. Buffett has paid out more than half of the $3.4 billion in upfront fees his Omaha, Nebraska- based firm got on the contracts through the end of 2008.
The 78-year-old billionaire’s bet that he could outwit traders he once derided as “geeks bearing formulas” may be foiled by the biggest surge in corporate failures since at least 1970 and a plunge in the amount investors recover after default. Buffett has said Berkshire may lose money on the derivatives tied to high-yield, high risk debt, which typically last about five years.
“We effectively had a near-collapse of the system and default rates spiked and recoveries were extremely low” after the failure of Lehman Brothers Holdings Inc. last September, said Mikhail Foux, a credit strategist at Citigroup Inc. in New York. “That effectively killed this strategy” used by Buffett.
Buffett agreed in some trades to take the first losses if companies in high-yield indexes default, betting that upfront fees would exceed payments he had to make. He said in letters to shareholders that traders relied on models that created “wildly mispriced” trades. Buffett manages the trades personally, he said in the 2006 annual report, and Berkshire may also profit from investing the premiums.
Five-Year Contracts
Buffett didn’t respond to requests for comment left with assistant Carrie Kizer. He disclosed the latest figures on the swaps in an Aug. 7 filing in which Berkshire said that second- quarter net income gained 14 percent to $3.3 billion on separate derivatives tied to equity markets.
Berkshire typically guaranteed the debt of groups of 100 companies for five-year periods. The first swap expires Sept. 20 and the last one matures in December 2013, Buffett said in his most recent annual letter. In a worst-case scenario, Berkshire would face a maximum of about $6.4 billion in additional payments, according to the Aug. 7 filing.
At one point in 2005, Berkshire had been paid an average of 75 percent of the maximum loss upfront to take on such risk, according to Janet Tavakoli, founder of Tavakoli Structured Finance Inc. in Chicago, who wrote about Buffett’s credit swaps trades in her 2009 book “Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street.”
Recovery Rates
Holders of debt issued by non-financial companies recovered an average of 45 percent during the past two recessions, according to Moody’s Investors Service. That means Buffett in 2005 was getting paid an average 75 cents on the dollar to back bonds that, if they defaulted, typically lost 55 cents on the dollar during the last two slumps.
“People say he doesn’t understand derivatives,” Tavakoli said in an interview before the second-quarter results were announced. “He very much does know what he’s doing, but you have to be aware in any investment, the best you can do is build in a margin of safety.”
Historical assumptions failed in the crisis that toppled Lehman, pushed insurer American International Group Inc. to the brink of bankruptcy and sunk the global economy into the worst recession since the 1930s. Swaps sellers had to pay an average of 83.4 cents on the dollar to settle contracts on 26 companies this year, according to data from Markit Group Ltd. and Creditex Group Inc., which administer the auctions in which dealers set the payout levels. That means the recovery averaged 16.6 cents.
Smurfit-Stone
In January, six of the companies whose debt Berkshire had guaranteed defaulted, the company said in a filing, without naming the issuers. BH Finance LLC, a Berkshire unit, signed up for auctions in January allowing it to settle swaps linked to six borrowers including packaging-maker Smurfit-Stone Container Corp. and telephone-equipment company Nortel Networks Corp.
Sellers of swaps on Chicago-based Smurfit that signed up for the auction had to pay more than 91 cents on the dollar to settle the contracts. The payout on Nortel was 88 cents per dollar. During an auction to settle contracts on Lyondell Chemical Co., which BH Finance also signed up for, the payout was set at 84.5 cents.
Berkshire paid $97 million on its high-yield swap contracts in 2008, when Buffett was more optimistic about his bet.
“I told you a year ago that I thought we would make money on those, but we have run into far more bankruptcies in the past year,” Buffett said in Omaha at Berkshire’s annual shareholder meeting in May. “I would expect those contracts to show a loss before investment income, and perhaps after.”
‘Mass Destruction’
Berkshire posted a $391 million second-quarter gain on all of its credit-default swaps trades, as the market value of the underlying debt improved. The figure may includes bets on investment-grade corporate bonds and states and municipalities, in addition to junk borrowers. In the first quarter, the swaps reduced earnings by about $1.3 billion.
Projecting Buffett’s future losses is difficult because he doesn’t name the companies on which he placed bets, disclose terms of his trades or say whether he has hedged against any losses, Foux said.
Buffett may have fared better than investors that made similar trades using benchmark indexes that are created by the banks that dominated trading in the credit-default swaps market. A trader that bought the riskiest piece of the Markit CDX North America Investment Grade Index Series 9, for example, already would have been wiped out, Foux said.
Junk, or high-yield, high-risk, bonds are those rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s.
To contact the reporter on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net
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