Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [13]
Warren maintains that long dated (15- or 20-year maturity) equity index puts on the FTSE (a UK stock index) and the DOW, among other indexes, are mispriced. Investment banks price the options based on volatility, irrespective of the absolute level of the indexes. Investment banks enter into these very long-dated put options struck at the market—today’s market level—and they are European puts, exercisable only once—at the expiration date many years in the future.
Most of the option models assume that prices vary around today’s level, and the models do not take into account the probable growth of the economy. Even if a model takes growth into account, it usually woefully underestimates it along with the future value of the stock market. This is a common error, and when Warren finds someone willing to do these mispriced trades with him in size, he jumps on the opportunity.
Options are a natural fit for insurance companies that are part of the Berkshire Hathaway conglomerate. When Warren sells a put buyer the right to make him pay a specific price agreed today for the stock index (no matter what its value 20 years from now), Warren receives a premium. Berkshire Hathaway gets to invest that money for 20 years. Warren thinks the buyer, the investment bank, is paying him too much. The stock index could have a lower than today’s market price (fat chance), but unless there is a global economic disaster, it is highly unlikely. Furthermore, Berkshire Hathaway invests the premiums that will in all likelihood cover anything it might need to pay out, and it is most likely, it will never pay out anything at all, since the stock index is likely to be higher than today’s value.
It is as if the models were predicting the future net worth of an entire Harvard MBA class based on their first job out of school. It is possible they won’t be worth more in 20 years, but it isn’t likely, since their earning power is likely to rapidly grow.
Warren doesn’t need a complex option model to tell him that the options are mispriced; he only has to look at the strike price, the proposed level of the index, to know that the other guy’s model is wrong. Warren takes large upfront premiums in exchange for agreeing to make a payment in 15 or 20 years that in all probability will never need to be made. In the meantime, he employs the cash premiums for the benefit of Berkshire Hathaway.
In the 2007 shareholder letter, Warren told shareholders: “We have received premiums of $4.5 billion, and we recorded a liability at year end of $4.6 billion.” Another winning feature of this trade is that Berkshire Hathaway has zero credit risk. In the unlikely event that a payment is made 20 years from now, the put buyer is relying on Berkshire Hathaway to make a payment. Berkshire Hathaway is not depending upon an investment bank to make him a payment if the market is so troubled that stock index level is below today’s level; an investment bank would probably be wiped out. Berkshire Hathaway, on the other hand, is likely to be doing much better than other companies in that scenario. Even the required payment on the put option in 20 years will be buffered by the fact that it is only a small part of Berkshire Hathaway’s portfolio and it is partially offset by the value of the premiums in 20 years.
Warren also noticed that credit derivatives are often mispriced. When this occurs, he earns upfront premiums for taking default risk on baskets of high-yield ( junk) bonds. When junk bond yields are very high and most investors avoid them,Warren will enter the market when he can be handsomely compensated to take the risk of carefully chosen companies. Warren invests when the prices are right; but he is happy to do nothing for years when the price for the risk is not right.
Warren is aided by the fact that most investment banks use sophisticated Monte Carlo models that misprice the transactions. Some of the models rely on rating agency inputs, and the rating agencies do a poor job