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Has Berkshire Lost Its Hathaway?
How is Buffett doing in his plan to take over the municipal bond insurance market? The Berkshire Hathaway shareholders meeting featured a discussion of progress to date, as well as the potential risk to the financial system posed by the large amount of outstanding credit default swaps. For a person who once characterized derivatives as financial instruments of mass destruction, Buffett is very comfortable with them, remarking that Berkshire has written two types of them and expects to make very good money doing so. These instruments aren't that scary, apparently, when he is using them.
On bond insurance, Berkshire wrote 400 million premium during the first quarter, more than any other player, and possibly more than all others combined. Buffett was very pleased with Ajit Jain's performance: he was able to command a premium of 2.25% in order to backstop insurance that was originally written at 1%. That to me illustrates Buffett's approach - he always has extra capital and employs it to write risks at generous premiums when market conditions permit. This opportunitic approach serves him well but may limit Berkshire's long term prospects in the muni-bond business, as other players return to the market and rates return to normal.
There has been a lot of concern lately that the counterparty risk on the 60 trillion of CDS outstanding as of the end of last year may lead to a collapse of the financial system. Asked to comment on the topic, Buffett's response seemed to lean toward the idea that it's a zero sum game: there will be winners and losers, but to the financial system as a whole the outcome doesn't make any difference. He doesn't think the amount of CDS in and of itself will cause a problem, although it would exacerbate chaos in the event of financial stress from other sources, such as the Bear Stearns crisis.
Read the rest of my thoughts on Berkshire Hathaway and where it's headed.
Buffet's partner, Charlie Munger, endeared himself to me by commenting that the amount of CDS insurance on some bonds greatly exceeded the face amount of the bonds, leading to efforts to make the loss bigger so the payout would be bigger. Then he talked about how in life insurance it used to be illegal to buy insurance on people you didn't know, to get a big payout on their death. This plays to my pet peeve, the moral hazard created by permitting credit default swaps without any requirement of an insurable interest. Munger criticized this is reflecting inadequate regulation, an opinion I heartily agree with.
Apparently recording devices are not allowed at the Berkshire Hathaway shareholders meeting. I found a fairly detailed set of notes on Seeking Alpha, where I have occasionally been able to find transcripts of earnings conference calls. After reading the notes, one thing that stood out to me was that a large part of Buffett's strength comes from always having extra capital. He has been criticized recently due to the amount of cash on hand at Berkshire, but over the years he has been able to achieve a lot by always being fully credible and always being able to write a check.
Berkshire is a formidable competitor in the triple A rated bond insurance business, because total crediblility of the insurer is necessary to achieve its desired effect of reducing the borrower's interest costs. While I don't think the realities of competition will enable Berkshire to maintain the very high premiums they have received to date, it is possible that this credibility may crate a situation where Ambac (ABK) and MBIA (MBI) will need to go to great lengths to demonstrate that they are equally as solid. One thing is certain - Berkshire is a responsible competitor and will not write coverage at inadequate premiums. That may make the business more profitable for all insurers going forward.
Buffett's words of wisdom are always worth reading - but, is Berkshire Hathaway a great investment today? Buffett himself thinks returns will be less in the future than they have been in the past, mainly because given Berkshire's size there simply aren't enough big opportunities out there to generate outsize returns. He said he would be happy if they could earn 10% pretax, including dividends - margins less than in recent years.
First quarter 2008 results were not impressive: revenue was down, primarily due to unwillingness to write reinsurance at inadequate rates; and EPS were down, primarily due to mark to market losses on derivatives, which management does not regard as significant or permanent. The property and casualty business is cyclical, and in the current competitive environment Berkshire's growth and earnings will be affected.
Berkshire has traded at a well-deserved premium for many years: but given the difficult insurance environment, decreasing margins and growth will put pressure on share prices. While the successful entry into the bond insurance business is a coup, earnings were not material to Berkshire's results and will not be for some time. I would not buy Berkshire at today's price, which seems to reflect unrealistic expectations about future growth and profitability.
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