Tuesday, November 25, 2008

Certifiably Crazy

The recent sell-off in Berkshire Hathaway's (NYSE: BRKB) stock has been nothing short of astonishing. But it is perhaps another sign of fear creeping into investors' psychology. Hand in hand with that decline has been a dramatic rise in the value of the company's credit default swaps implying the AAA-rated conglomerate's credit should be considered junk. Whitney Tilson's article published by Seeking Alpha is a great read on this subject. He calls the stock's dramatic decline "certifiably crazy".

Mr. Buffett himself warned of the derivative time-bomb in his 2002 letter to shareholders. Who in their right mind would think that one of the best investors of our lifetime would ignore his own words of wisdom and enter into such perilous contracts? The equity index put options written against 4 indexes appear to be causing the most angst for Mr. Market. Never mind that the contracts do not require him to post barely ANY collateral even in the event these indexes decline dramatically and that any losses recorded on the books are merely paper losses and nothing more. Never mind that the first contract won't expire until 2019 and that they have an average life of 13.5 years. Never mind that according to a just released email from Mr. Buffett, the value of the indexes would have to decline to ZERO for Berkshire to incur a loss equal to its maximum exposure of $35.5 billion. And never mind that he has gotten paid $4.85 billion in premiums for those contracts which he may invest as he wishes.

Mr. Buffett has indicated that he will provide much greater detail about these contracts in his 2008 shareholder letter and that he will provide "all aspects of valuation" and "deficiencies in formula" for pricing the derivatives. He goes on to say that he uses the formula despite the deficiencies. Classic Buffett to point out the shortcomings of the formula. This should make for some fascinating reading.

In a sign of the times we live in, Berkshire's stock has already rallied 28% from the lows they hit last week. They closed today at just over $3,200. Something is not right when you witness this kind of volatility in Berkshire. But it is precisely in the midst of this confusion that you should be taking advantage of the buying opportunities being presented by Mr. Market. Mr. Tilson has. He has doubled his holding in Berkshire by committing 20% of his fund to the stock.

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