Nothing to see here, move right along February 6, 2014 at 9:40 pm

Dear me, can’t a billionaire write a bunch of long-dated exotic derivatives without those pesky kids sticking their noses in? Warren is getting a rough ride from Dan McCrum repeatedly, and today from Matt Levine, and he doesn’t quite deserve it. Here’s why.

  • First, level three assets are not necessarily toxic. They can just be hard to value precisely. Even if Warren had just sold 20 year plain vanilla equity index puts, they would be level three, as there is no ready market in twenty year implied vol (although you can make a pretty decent guess from where the ten year is).
  • Warren is naked short. Black Scholes and related approaches are valuation techniques which work if you are hedging (and you can indeed replicate the derivative by following your model’s hedge ratios). There is actually quite a good theoretical argument (if not an accounting standards one) for him not to mark to market – an argument that would be more convincing if he has written an insurance policy that is then transformed into a derivative via an SPV. We don’t know that he hasn’t done this. But we do know for sure that Warren’s strategy is to write insurance and invest the premiums. As long as he collects enough premium and his risks are diversified, he’s happy: for him, at least at 50,000 feet, the business model is all about collecting premiums and investing them. Writing long-dated puts is a good way to raise cash – as long as you don’t have to post collateral (which Warren didn’t).
  • Even if he has written a worst-of put, this was not a particularly exotic derivative in 2006-7. Back then people were playing with a whole range of basket options (see for instance the mountain range trades originated by Soc Gen’s traders and rapidly taken up by the rest of the street). While these trade types might not be in options 101, they haven’t been cutting edge for twenty years.
  • One of the hard things about running an equity derivatives book is getting enough long-dated vega. No one wants to sell it; everyone wants to buy it.
  • So the reason there was a trade is the age-old two people wanting different things. Warren wanted cash, and saw the premium as good compensation for the insurance he was writing. His counterparties saw cheap vega that was hard to buy any other way, and a good credit. Two well informed parties with different takes on the world trading with each other is not, I am afraid, a scandal.

4 Responses to “Nothing to see here, move right along”

  1. One of the hard things about running an equity derivatives book is getting enough long-dated vega. No one wants to sell it; everyone wants to buy it.

    yup to this; have often described a big options counterparty as “a massive edifice of intellectual and human capital that can never be anything other than short volatility and long dividends because it is too big”.

  2. I’m with David if for no other reason than what appears to have happened here is that Berkshire has written insurance which is a business they happen to be in and are demonstrably pretty good at. Yawn.

    What does Lehman Brothers do again?

    dsquared: If that edifice is massive enough they don’t *need* to be anything other than short volatility and long divs because, especially post-2008, their systemic, regulatory and political clout gives them leverage and any number of “puts” that even smarter, more nimble but *smaller* market participants (including Dick Fuld evidently) simply don’t have.

    Levine writes: “Got that? Lehman cooked up a worst-of put option that was worth $221.5 million to it. Then it convinced Berkshire to sell it that put option for $205 million, making it a (mark-to-market) profit of $16.5 million on the first day”

    Where does it say that “MTM” means “market-to-market” and what market are they referring too? This has to be a mark-to-model valuation even if Lehman claimed otherwise.

    So, regardless of how wise it is for Buffett to be getting himself involved in such a position (he is, BTW, unlikely to be alive at expiration) it’s ridiculous to claim (based on the evidence presented) that Lehman outfoxed Uncle Warren with its superior risk pricing skills especially in light of what has happened to LEH and BRK respectively in the meantime.

  3. Don’t think Levine is saying anybody outfoxed anybody. He is merely theorizing that Lehman took a profit becuase it was WB who actually wanted to trade, not Lehman looking to portfolio hedge, and thus he payed Lehman their fair amount for dealig with him. He supports this view with evidence that Lehman then went out and at least partially hedged the trade w/ other options, implying that Lehman didnt already have the portfolio in place requiring this kind of hedge.

    Furthermore, later in the article, Levine explains how thin a profit of ~17mm is on a trade like this.

    In other words, the ~17mm is the b/o spread, or MM PnL.

  4. Levine: “Got that? Lehman cooked up a worst-of put option that was worth $221.5 million to it. Then it convinced Berkshire to sell it that put option for $205 million, making it a (mark-to-market) profit of $16.5 million on the first day.”

    Sounds like he thinks Lehman outfoxed Buffett to me (not to mention the title on the piece) although he does temper that later with a: “You’re really not supposed to rip off Warren Buffett” since that $16.5mm “profit” amortized over 20 years is only 8 bips. But so what? that calculation and the paper profit claim on T+1 of a 20 year deal (which is the crux of the whole article) means nothing. Mark-to-today that $16.5mm is negative something huge and if the puts expire out of the money (almost a certainty the way CBs are driving), Lehman’s side of the trade will have netted minus $205mm. minus whatever hedge they put on, minus overhead and minus opportunity costs.

    Unless I’m missing something it sure looks like Buffet is holding a fat bag of premium cash right now and (what’s left of ) Lehman is holding…a rainbow.