For the Week Ahead:
On StockTock.com, StockJock made a compelling case for a capitulation bottom. It certainly looks that way. However, I am not yet sure that this is THE bottom. For full disclosure, on Friday I closed all my puts and bought calls on Apple.
On Friday, all three major indices closed with a bull-flag formation (see e-mini chart for Friday). Currently futures are indicating a 4% higher open on Monday. I would like to trade during this week with a cautious but bullish bias. However, I am concerned about the market based on the Friday’s action in two stocks: Morgan Stanley and Goldman Sachs. Both stocks closed BELOW their Sept lows. I cannot emphasize enough how troubling this is. If the market rallies on Monday morning and these stocks don’t participate, I WOULD GET THE HELL OUT of this market.
What Seems to be the Problem?
What we are witnessing is a derivatives melt-down accelerated by deleveraging. On the debt side the biggest culprit seems to be credit default swaps and on the equities side naked puts on indices. The domino effect definitely started with Lehman’s bankruptcy. Credit freeze and deleveraging accelerated the equity sell off. On Oct 1st and 2nd several primary dealers issued margin calls to several hedge funds and rised margin requirements from 15% to 35%. The sell off during the last week was so severe because the funds rised cash to meet the margin calls. I read a report which indicated that margin-call related selling couldgo on even on Monday as some funds have time till Oct 13 to meet the margin calls.
Little did I know that these biggies are trading with only 15% margin. This is utterly silly and dangerous. What I can’t understand is that all the protections put in place after the Market Crash of 1929 and the Great Depression were essentially negated during the last decade. Margin rates prior to 1929 crash were 10%. Until recently margin requirements in equity accounts is 50%. What were they thinking? Also, we all know how the repeal of Glass-Steagall Act (which was originally enacted to prevent another Great Depression from happening) contributed to the development of shadow banking system via the Bear Sterns, Lehmans and Goldmans of the world with as high a leverage as 50 to 1. We know what happened with this kind of leverage and unregulated
The Problem of Dynamic (Delta) Hedging
What is dynamic hedging? There are two sides to each trade. A buyer and a seller. Buying and selling underlying assets like real estate or bonds or even shares is never a problem to the health of any market.
Not so with derivatives market. If the options sellers sell covered calls and covered puts, the risk is limited. However, it is the naked sales of puts (or even calls) on major indices is something that can wipe out even the big houses when the indices move too much and too fast against them. The guy who sold the puts naked might have done so thinking that it is easy money. His original strategy might have been to short the market if and when market goes down to certain level. This is called dynamic hedging or delta hedging. Under normal corrections, the houses and big hedge funds will have enough liquidity to turn things in their favor and make the options they sold worthless.
What we are witnessing is no ordinary correction. Even big houses are broke. Heck, even the government is broke. Unless this market quickly turns around, those sellers of naked puts on indexes will be broke.’
et tu, Buffet?
None other than Warren Buffet (through his Berkshire Hathaway) is stuck in this derivatives mess. When I first heard rumors about Buffet getting stuck in derivatives trade, I dismissed the rumors. This week Barron’s had an article on this.
Buffett’s Berkshire, meantime, fell sharply last week, as its class A shares dropped over $25,000, or 18%, to $113,100. Berkshire’s equity portfolio, which stood at $69 billion on June 30, is falling in value, although it’s ahead of the major averages this year. Berkshire has written, or sold, long-dated put options on some $40 billion of equity indexes, including the S&P 500. Those put sales, which amount to a bullish market bet, are deep in the red, although Berkshire doesn’t have to post collateral against any paper losses. We estimate those puts could have cost Berkshire as much as $2 billion in the third quarter and several billion more dollars this quarter, with the S&P down over 20%. Berkshire ultimately may score with these puts if they expire worthless at maturity between 2019 and 2027. But the normally savvy Buffett made a mistake investing in financial derivatives, about which he has long warned. Berkshire had no comment.
Buffet gave several lectures on the ill effects of the monster called derivatives. Apparently he didn’t take his own advice. Are the put premiums too good for him to pass? This explains why he is so heavily pushing for the bailout. He called this sell-off an “Economic Pearl Harbor.” Now I know why. There goes my respect for the man whom I thought is the most honest man in America.
Closing remarks
It is very likely that Buffet’s news is already priced in to the market. Also, the powers that be may have one more trick to prop the markets during the expiration week. That is why I am cautiously bullish for this week.
Don’t forget, if the market goes up on Monday morning and if Goldman Sachs and Morgan Stanley don’t participate, there is a high probability of 20%+ single day crash within the next 10 days.
BE CAREFUL EVERYBODY. PROTECT YOUR CAPITAL FIRST.
Good post Mohan, though you are a little rough on Warren. I would take Warren’s investment acuity over Barron’s any day of the week. Barron’s I recall advised GM was a buy when it was at 17 dollars a few months back.
With respect to Warren, here are excerpts from his shareholder letters of 2006 and 2007 which speak to Berkshire’s derivative positions:
From the 2006 letter: “I should mention that all of the direct currency profits we have realized have come from forward contracts, which are derivatives, and that we have entered into other types of derivatives contracts as well. That may seem odd, since you know of our expensive experience in unwinding the derivatives book at Gen Re and also have heard me talk of the systemic problems that could result from the enormous growth in the use of derivatives. Why, you may wonder, are we fooling around with such potentially toxic material? The answer is that derivatives, just like stocks and bonds, are sometimes wildly mispriced. For many years, accordingly, we have selectively written derivative contracts – few in number but sometimes
for large dollar amounts. We currently have 62 contracts outstanding. I manage them personally, and they are free of counterparty credit risk. So far, these derivative contracts have worked out well for us, producing pre-tax profits in the hundreds of millions of dollars (above and beyond the gains I’ve itemized from forward foreign-exchange contracts). Though we will experience losses from time to time, we are likely to continue to earn – overall – significant profits from mispriced derivatives.”
From the 2007 letter: “Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories. First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7
billion. We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our year end liability for this exposure was recorded at $1.8 billion and is included in “Derivative Contract Liabilities” on our balance sheet. The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were
struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period. Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk. Second, accounting rules for our derivative contracts differ from those applying to our investment
portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.
Thus, our derivative positions will sometimes cause large swings in reported earnings, even
though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.”
Warren is involved in derivatives, but there are several important points that I think are critical. (1) There is no opacity about the positions, he is upfront about the positions and the exposure and the effect it can have on quarterly earnings, (2) Buffet himself is personally handling the positions, (3) there is no counterparty risk, (4) the premiums earned on the derivatives (the float) are being deployed into investments and are earning additional income, and (5) the exposure to Berkshire’s balance sheet is negligible and more importantly is not exaggerated by leverage. Could he lose on the derivative bets? Sure. Just as Berkshire’s insurance companies could be called to payout on a catastrophic weather event. But as Buffet notes, ” Don’t think, however, that we have lost our taste for risk. We remain prepared to lose $6 billion in a single event, if we have been paid appropriately for assuming that risk. We are not willing, though, to take on even very small exposures at prices that don’t reflect our evaluation of loss probabilities. Appropriate prices don’t guarantee profits in any given year, but inappropriate prices most certainly guarantee eventual losses. Rates have recently fallen because a flood of capital has entered the super-cat field. We have therefore sharply reduced our wind exposures. Our behavior here parallels that which we employ in financial markets: Be fearful when others are greedy, and be greedy when others are fearful.”
For those interested, Buffet’s annual letter to shareholders is a joy to read and give great insight into his style of investing and management. They are posted on the berkshire website at: http://www.berkshirehathaway.com/letters/letters.html
BTW, great info on the put activity you noted a few weeks back on the xli. Those that followed the money into the 30, 28 and 27 strikes have done nicely. I also believe you had the call on the COF puts, when COF was in the mid 50′s. Another good call! Thanks for all your hard work, it is appreciated.
I used to read his letter to investors. I haven’t been reading that stuff recently.
I still respect Buffet a lot. He is the man!! These positions may have been taken without his knowledge. Even if he did sell those puts knowingly, he is only human.
Great post Mohan! One more question from me…. If naked short selling on stocks is forbidden, how come it’s aloud on derivatives? And what’s the practical difference between issuing naked puts and ordinary puts.
I don’t expect an answer right away. But when you have time and energy… Or maybe you can recommend something I could read on the issue? (something like derivatives for dummies
) I understand the basics, but dynamic delta-hedging and naked puts/calls are a whole new lever for me.
This might explain Buffett’s recent positions in GE and GS and put them in a new light. Was he protecting his derivatives plays from the “other side” cutting off or at least hindering the inevitable?
As for the CDS issues, stock price drives everything is my understanding. I believe this is why the TARP includes provisions for the fed to be able to purchase equities. As the market recovers we get further away from the CDS issuse (at least as a total death blow to everything). Fed will be able to come in and correct or make whole some of these companies on the brink and prop up the market at the same time. They have a lot of bullets in their gun now and can react to almost any situation. If they run out of bullets (which they may over the mext year), they’ll be able to get another clip with a full 15 rounds to finally blow away this massive problem. We’ll come out fine over time, but will we learn and what price will we have to pay?
Excellent post as usual Mo. Always appreciate your commentary. Brian had an excellent followup.