By Erik Holm and Shannon D. Harrington
March 4 (Bloomberg) -- The cost of protecting against default by Warren Buffett’s Berkshire Hathaway Inc. soared to record levels more typical of junk-rated companies amid concern the firm faces losses on derivatives.
Credit-default swaps used to guard against losses on Berkshire’s debt climbed 15 basis points to 515 basis points at 3:45 p.m. in New York, according to CMA DataVision, and earlier reached 535. The contracts yesterday traded as if the company, rated Aaa by Moody’s Investors Service, were 11 grades lower at Ba2, according to data from Moody’s capital markets research group.
The price may be rising on concern the Omaha, Nebraska- based firm will lose bets on the direction of world equity markets, high-yield corporate bonds and municipal debt. That scenario assumes Berkshire would drain its $25.5 billion cash hoard and then find itself unable to raise more from stock or bond sales or the company’s historically profitable insurance and utility businesses.
“There are two extremes on Berkshire, and one is that he’s going to make a lot of money on these things, just like he’s promised,” said Jeff Matthews, the author of “Pilgrimage to Warren Buffett’s Omaha” and founder of hedge fund Ram Partners LP. At the other extreme, investors worry that “he could in fact suffer huge losses and it could really trigger some problems,” Matthews said.
American Express, AIG
The price of Berkshire’s credit-default swaps put it on par with buying protection on American Express Co., the biggest U.S. credit-card company by purchases, which are trading at 543 basis points.
Berkshire swaps still are about half the 1,102 basis points for protection on American International Group Inc., the insurer that this week recorded the largest quarterly loss in U.S. corporate history. And investors are demanding the equivalent of 948 basis points to protect the bonds of the Aaa-rated finance arm of General Electric Co.
Credit-default swaps, used to hedge against losses or to speculate on the ability of companies to repay their debt, rise as investor confidence deteriorates. A basis point on a credit- default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.
Buffett, who has gained a reputation as the world’s pre- eminent stockpicker, has struck deals with unidentified firms to protect them against long-term declines in four equity indexes, defaults by a group of corporations with junk-bond ratings, and the inability of states and municipalities to repay their debts. Junk bonds are high-yield securities graded below BBB- by Standard & Poor’s and Baa3 by Moody’s.
The maximum loss on those bets was $63.4 billion as of Dec. 31, a figure that Berkshire would pay only if the markets fell to zero and all the states and municipalities failed to pay. Berkshire said liabilities on those positions were about $14 billion as of Dec. 31.
“Just to be investing out there means he’s exposed,” said Scott MacDonald, head of research at Aladdin Capital Management in Stamford, Connecticut. “And I think what was the shocker to people is that the sage of Omaha has suddenly shown he’s human.”
Buffett didn’t immediately respond to a request for comment left with assistant Carrie Kizer.
“Our expectation, though it is far from a sure thing, is that we will do better than break even” on derivatives, Buffett wrote in his annual letter to shareholders Feb. 28. Berkshire held about $8.1 billion as of Dec. 31 that it collected through the contracts, and can make money by investing those funds, Buffett wrote.
Berkshire’s fourth-quarter net income fell 96 percent to $117 million, the firm said Feb. 28. Book value per share, a measure of assets minus liabilities, slipped 9.6 percent for all of 2008, the worst performance under Buffett’s watch, on the falling price of stocks in the firm’s equity portfolio and the declining value of the derivatives.
“They’re all paper losses, and he doesn’t owe money on any of it for years,” said Guy Spier, principal at hedge fund Aquamarine Funds LLC, which owns Berkshire shares. “People are doing crazy things in this market right now, but if you just stop and ask about the logic of it, it doesn’t make any sense.”
A total of 2,400 credit-default swaps protecting a net $4.4 billion of Berkshire debt from default were outstanding as of Feb. 27, according to the Depository Trust & Clearing Corp., which runs a central registry for the market.
“It could very well be that the insurance company or whoever it is who bought the derivatives are now buying the CDS to make sure they get paid,” Matthews said. “It’s a lot like a stock price, where it’s hard to know what makes it go up or down.”
Berkshire’s stock has fallen 45 percent in the past year, compared with the 46 percent decline in the benchmark Standard & Poor’s 500 Index. The shares gained $25 to $75,025 at 4:01 p.m. in New York Stock Exchange composite trading.
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