Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [15]
A couple of years before I met Warren, a Wall Street firm paid Berkshire Hathaway to take the risk of the first corporation to default in a basket of junk debt.Warren only considers deals he knows are mispriced, and he has a couple of conditions. He chooses the specific corporate names; he refuses “diversified” portfolios containing a large number of corporations. He does trades in massive size—$100 million or more, if possible.
The following is a simplified example. If one of a handful of pre-chosen corporations defaults, Berkshire Hathaway pays the original full amount for the debt, which is 100 percent of the first corporate name to default. Berkshire Hathaway then gets the recovery value—the market price of the debt.This price will depend on the remaining value of the company. Warren happily enters this type of credit derivative trade, when he can create a margin of safety—when Wall Street pays him so handsomely in an upfront premium that it exceeds anything he might lose if one of the companies defaults.
When Collins & Aikman defaulted and filed for bankruptcy in June 2005, Berkshire Hathaway recovered 35¢ on the dollar, or put another way, it “lost” 65¢ on the dollar. David Stockman, the director of the Office of Management and Budget during President Ronald Reagan’s administration, was Collins & Aikman’s CEO and stepped down the week before the bankruptcy was announced. In March 2007, he and other top officers were charged by a New York federal grand jury with conspiracy, several counts of fraud, and obstruction of justice. Allegations are that, among other things, loans were disguised as revenues and revenue was booked before it was earned. U.S. Attorney Michael Garcia said: “They resorted to lies, tricks and fraud.”11 Warren’s margin of safety greatly increases the likelihood he will make money, even when an unexpected event like this occurs.
It is more important to have a margin of safety to protect oneself against a Black Bart—someone fancying himself to be an offspring of the famous Wells Fargo stagecoach robber—than a rare Black Swan type market event. Berkshire’s “loss,” given that the Collins & Aikman default occurred, was 65¢ on the dollar, but Berkshire had received much more than 65¢ on the dollar in upfront premiums. On average, Berkshire Hathaway had taken in around 75¢ on the dollar in upfront premiums.
Warren does these trades in very large size. For example for every $1 billion of transactions, Berkshire stands to lock in $100 million (or more), if there is a default. Meanwhile, it has the use of $750 million in premium money it puts to good use. In 2005, Warren had $1.5 billion in premiums to put to work. Isn’t that adorable?
Normally, first to default trades are viewed as the riskiest trades, and junk debt is viewed as the riskiest kind of asset; but Warren builds in a margin of safety that makes this a wise investment as long as Wall Street misprices the risk.Warren Buffett has figured out the safest way to take junk risk in the history of junk debt.
Investment banks could put on the same trades if they did fundamental analysis of the underlying companies, but they are too busy playing with correlation models. Banks and investment banks have become invisible hedge funds putting risk on their balance sheets that they cannot quantify. Meanwhile, Warren Buffett models the risk in his head and profits.
Warren has another advantage: Wall Street underestimates him.
In the fall of 2006, I was talking to a friend in New York, and I mentioned that Warren Buffett and I have similar views on credit derivatives, and—now comes the bragging