MICHAEL KINSLEY once defined a political gaffe as the moment "when a politician tells the truth" and is embarrassed by it. By that standard, Warren Buffett's deal to write $35 billion (€27 billion) of put options on equity markets was a financial gaffe.
On the face of it, Buffett's gambit looks both unwise and uncharacteristic. Shares in Berkshire Hathaway, his holding company, tumbled last week (they have since recovered) because it is nursing a mark-to-market loss of about $5 billion on the derivatives contracts.
In fact, a casual observer might question what Buffett, who once condemned derivatives as "financial weapons of mass destruction", was playing at when he bet that four equity indexes, including the Standard Poor's 500, would not be below their existing level in 2019 to 2027. Buffett conceded the point in his 2006 letter to investors. Such transactions, he wrote, "may seem odd . . . Why, you may wonder, are we fooling around with such potentially toxic material?"
The Berkshire Hathaway that we know and admire is a folksy kind of place where Buffett strikes handshake deals to buy big, solid US companies that do things we all understand.
But selling options is typical of how Buffett has funded Berkshire Hathaway since he first acquired an insurance company in 1967. His business model relies on being paid fees - insurance or option premiums - in return for bearing the risk of future losses. The cash bankrolls him to buy shares in, or the whole of, firms such as Coca-Cola or Wrigley.
Any Berkshire Hathaway investor is taking a tiny risk that, one day, Buffett will miscalculate one such bet and the company will be felled by a catastrophic loss. It has not happened so far, but nor did American International Group, another US insurer, need to be bailed out until two months ago.
That is why credit default swaps on Berkshire Hathaway have traded at high prices as banks and investors have adjusted to the notion, unthinkable until recently, that it could go bust. The company shows no sign of doing so, but the idea is not entirely fanciful.
In The Snowball, her biography of Buffett, Alice Schroeder records that when he bought the Nebraska insurer National Indemnity in 1967 to diversify Berkshire Hathaway out of textiles, "Buffett had figured out a whole new type of business. If National Indemnity made money, he could send those profits out to buy other businesses and stocks."
Berkshire Hathaway's funding base has grown steadily since then. It now owns Geico, the car insurer, and General Re, the reinsurer. Its biggest risks are taken by BH Reinsurance, which covers, as Buffett puts it, "huge risks that no other reinsurer is willing or able to accept", such as hurricanes and earthquakes.
Buffett's equity options, which he wrote himself, fall into the category of insurance-like funding. He got premiums of $4.5 billion for promising to cover the losses of other investors if, in 15 to 25 years, the share indexes have fallen below their level when the contracts were struck.
The $4.5 billion is akin to an insurance premium, or float. Berkshire Hathaway can reinvest the cash while waiting to see how much money it eventually has to pay in claims. Its overall float is now vast - it increased from $18.5 million in 1967 to $58 billion last year, allowing it to make deals such as its purchase of $5 billion of preferred shares in Goldman Sachs in September."Float is wonderful - if it doesn't come at a high price," he has written in shareholder letters. His point is that Berkshire Hathaway does well as long as it avoids chronic underwriting losses, because the float builds up over time and finances the rest of the business.
So far, Berkshire Hathaway's underwriting standards, and estimates of potential loss, have been strong. In his 2004 letter, Buffett estimated that if there were a $100 billion disaster, its share of the loss would "probably be 3 to 5 per cent". Hurricane Katrina, in 2005, cost Berkshire Hathaway $3.4 billion.
His options will probably work out too. The mark-to-market loss is only just above the premium paid (without counting the investment income on the cash) at a time of historic stress, and no actual cash loss can occur for another 11 years.
It raises the question of whether Buffett is as canny an underwriter as Ajit Jain, who runs his catastrophe reinsurance business. Berkshire lost $3.4 billion on a physical disaster, whereas Buffett is on the hook for a lot more from financial volatility.
It also illustrates Berkshire Hathaway's vulnerability to a "black swan" loss of the kind that has struck various institutions recently. Buffett's approach of insuring events he thinks are unlikely to occur is the kind of trading strategy criticised by Nassim Nicholas Taleb, who wrote The Black Swan. None of this means we should lose faith in Buffett, as the market briefly seemed to do last week. He has never hidden the risks involved in obtaining cash float. He has gone out of his way to explain them in his shareholder letters.
We should not be shocked that he is taking on big financial risks. That is what he has always done. So I trust Berkshire Hathaway while 78-year-old Buffett remains at the helm. The only thing that worries me is that he may have a shorter expiry date than his options. - ( Financial Timesservice)
