Berkshire Part 2: Selling Puts

Buffett has pulled it off again. He’s made a creative, favorable bet that may pay off handsomely for long-term Berkshire shareholders.

Over the past year, Berkshire Hathaway sold put options on the S&P 500 and three foreign indices. Expiration of these puts range from 12 to 20 years out, and Berkshire collected $4.5 billion in premiums. Unlike regular puts, these are exercisable only at their expiration dates. On those dates, Berkshire makes a payment only if the index has lost money over the period of the option.

Selling these puts is essentially saying: In 15 years, I promise to buy the S&P 500 from you at a price of $1,468 (closing 2007), if it trades below that price. In exchange, you give me $4.5 billion right away.

Buffett doesn’t disclose the size of the actual options. The $4.5 billion in premiums tells you they are big, but apparently not big enough relative to Berkshire to cause any problems.

The counterparties (the people who made the agreement and paid the premium) are most likely large financial institutions who are hedging their long-term bets in favor of the market. So it may turn out to be a dumb bet for them, but they’re essentially purchasing insurance on what they have or will have in the market.

For Berkshire to lose money, a few things have to happen. To keep it simple, let’s just talk about the S&P 500, because we don’t know which foreign indices were used.

  1. First, over the next 12 to 20 years, the market would have to have a negative cumulative return.
  2. Second, that negative return would have to be large enough to overcome the premiums received.

How large? Once again, we don’t know the size of the options. But the premiums, which were $4.5 billion at the time they were written, will have compounded for more than 15 years by the time of expiration. If Buffett (or future Berkshire managers) can achieve 15% annual returns, the premium cash will have grown to over $36 billion. So the aggregate losses on the put options—the size of the options times the amount of negative returns—would have to exceed $36 billion for any profits to be erased.

Because of their long-term length, it mitigates the risk of a short-term Black Swan-type event affecting the options. A “Black Monday” one day anomaly would have little effect, other than a temporary quarterly adjustment. Something could still happen (i.e. a long depression, or a nuclear war, God forbid) that would cause losses. But this bet seems pretty favorable as long as the world economy does alright in the long run. Chalk one up for the Oracle of Omaha.

7 thoughts on “Berkshire Part 2: Selling Puts”

  1. For those still interested, I found these 2 quotes after reviewing the entire Berkshire annual report (not just the letter):

    “As of December 31, 2007, Berkshire’s maximum exposure under these contracts was approximately $40 billion…”

    “If the underlying indexes declined 30% immediately, and absent changes in other factors required to estimate fair value, Berkshire estimates that is could incur a non-cash pre-tax loss of approximately $2.3 billion.”

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  2. 4.5BN in premiums sounds about right — and of course the potential losses could be much larger than 4.5BN depending on the path of the market. I believe he’s selling mostly to Life insurers to help offset the mark-to-market portion of variable annuity living benefit guarantees

    I imagine Buffett is actually hedging the Delta position of the options and isolating Vega (since that’s where the illiquidity premium exists). This is probably a good bet — the implied vols are outrageous over such a long-term period (~30%)

    FYI – The 15% return assumption –> 36BN in premium value is pretty spurious — such an optimistic outlook would make selling 20-year CDs at 10% look like a windfall even though it would represent blinding stupidity. Something tells me Buffett doesn’t run his company that way

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