5/3/2008: Berkshire Hathaway, AIG, and fair value accounting for CDS's

It seems that even Berkshire Hathaway cannot escape the pernicious effects of fair value accounting.

The following are excerpts from Berkshire Hathaway's press release announcing Q108 earnings:

In the table at the top of the page (which, as noted, reports after-tax results), we give investment and derivatives gains (losses) a line of their own because the amount of these in any given quarter or year is usually meaningless.
...
[A]ccounting rules require that any unrealized gain or loss from derivatives contracts be regularly recorded in earnings. During the first quarter, Berkshire’s derivatives had an unrealized pre-tax loss of $1.6 billion. However, that is a “net” figure, incorporating gains and losses in several different kinds of derivatives. Fundamentally, the size of that figure reflects the fact that we recorded a $1.7 billion unrealized loss in our two major categories of derivatives.

In explanation of that loss, we will begin with the first of these major categories, credit default swaps (CDS). The ones we hold are related to various high-yield indices. As is explained in the section of our 2007 annual report that is appended to this release, at yearend Berkshire had received $3.2 billion in premiums on these CDS contracts and, to that date, had paid $472 million in losses. The contracts – with original terms of about five years – expire in years 2009 through 2013, and our yearend financial statements carried a liability of $1.84 billion for future losses. The weighted length of the contracts was then 42 months and was therefore reduced to 39 months by the end of the first quarter.

In the first three months of 2008 our paid losses were $52 million, considerably less than we expect to average on a quarterly basis. Despite this favorable experience, we raised our liability figure to $2.26 billion, an increase dictated by market changes that reflect heightened worries about corporate credit. That increase led us to record a loss of $471 million for this particular CDS group.

We also added some new five-year positions, receiving premiums of $229 million. On these contracts we paid no losses but established a quarter-end liability of $248 million, This gave us an additional loss of $19 million. Therefore our aggregate first-quarter loss on our CDS positions was $490 million (the total of $471 million and $19 million).

Overall, we now hold $2.9 billion of cash from CDS contracts, all available to us for investing as we choose. When prices are right, as they have been recently, we like the credit insurance business and believe it will be profitable, even without our taking into account investment earnings on the substantial funds we hold.

The press release also contains an excerpt from Berkshire Hathaway Inc.’s 2007 Annual Report – Chairman’s Letter, which states:

[W]e have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. ... I believe that on premium revenues alone, these contracts will prove profitable ... Our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.

The following are excerpts from Berkshire Hathaway's Q108 10-Q:

Under certain circumstances, including a downgrade of its credit rating below specified levels, Berkshire may be required to post collateral against derivative contract liabilities. However, Berkshire is not required to post collateral with respect to most of its long-dated credit default and equity index put option contracts. At March 31, 2008 and December 31, 2007, Berkshire had posted no collateral with counterparties as security on derivative contract liabilities.
...
Derivative gains and losses in the preceding table primarily represent the non-cash (or unrealized) changes in fair value associated with derivative contracts that do not qualify for hedge accounting treatment. As of March 31, 2008, outstanding derivative contracts primarily pertain to credit default risks of entities in the United States and equity price risks associated with major equity indexes, including three outside the United States. In the first quarter of 2008, pre-tax losses of $1.6 billion from derivative contracts were principally attributable to declines in equity indexes, declines in the value of the U.S. dollar versus the Euro and Japanese Yen, as well as a widening of credit default spreads in the United States.

The estimated fair value of credit default contracts at March 31, 2008 was approximately $2.5 billion, an increase of $667 million since December 31, 2007. The increase was due to fair value losses of $490 million, as well as $229 million in premiums from new contracts entered into in 2008 partially offset by loss payments of $52 million. The estimated fair value of the equity index put option contracts at March 31, 2008 was approximately $6.2 billion, an increase of $1.6 billion since December 31, 2007. The increase was primarily due to fair value losses of $1.2 billion as well as $383 million in premiums from new contracts entered into in 2008. There were no cash payments made under the equity index put option contracts.

The aforementioned contracts are not traded on an exchange. The contracts were entered into with the expectation that amounts ultimately paid to counterparties for actual credit defaults or declines in equity index values (measured at the expiration date of the contract) will be less than the premiums received. The contracts generally may not be terminated or fully settled before the expiration dates (up to 20 years in the future with respect to equity index put option contracts) and therefore the ultimate amount of cash basis gains or losses will not be known for years.

Berkshire does not actively trade or exchange these contracts, but rather intends to hold such contracts until expiration. Nevertheless, current accounting standards require derivative contracts to be carried at estimated fair value with the periodic changes in estimated fair value included in earnings. Fair value is estimated based on models that incorporate changes in applicable underlying credit standings, equity index values, interest rates, foreign currency exchange rates, risk and other factors. The fair values on any given reporting date and the resulting gains and losses reflected in earnings will likely be volatile, reflecting the volatility of equity and credit markets. Management does not view the periodic gains or losses from the changes in fair value as meaningful given the long term nature of the contracts and the volatile nature of equity and credit markets over short periods of time.
...
Berkshire’s estimated liabilities for credit default and equity index put option contracts were approximately $8.7 billion at March 31, 2008. Payments under the equity index put option contracts are contingent upon the future value of the related indexes at the expiration date of the contracts, the earliest of which is in 2019. Payments under credit default contracts are contingent on the occurrence of a default as defined under the contracts, and in the first quarter of 2008 were $52 million. The contract expiration dates begin in 2009.
...
The timing and amount of the payment of other obligations, such as unpaid property and casualty loss reserves and long duration credit default and equity index put option contracts are contingent upon the outcome of future events. Actual payments will likely vary, perhaps significantly, from estimates.

Note 6 of the 10-Q identifies the Berkshire's credit default swaps as Level 3 assets and describes the inputs for valuation of Level 3 assets as follows:

Inputs are unobservable inputs that are used in the measurement of assets and liabilities. Management is required to use its own assumptions regarding unobservable inputs because there is little, if any, market activity in the asset or liability or related observable inputs that can be corroborated at the measurement date. Measurements of non-exchange traded derivative contract assets and liabilities are primarily based on valuation models, discounted cash flow models or other valuation techniques that are believed to be used by market participants. Unobservable inputs require management to make certain projections and assumptions about the information that would be used by market participants in pricing an asset or liability.

Sabaziotatos says:

From the press release and the 10-Q, we may conclude:

1.) The CDS's are Level 3 assets.

2.) The increase in the liability figure for the CDS's was "dictated by market changes that reflect heightened worries about corporate credit." The phrase "market changes" refers to the "widening of credit default spreads." Thus, although the CDS's are classified as Level 3 assets whose valuation is based on "unobservable" inputs, the CDS's are being marked to market in the sense that their valuation reflects the widening of spreads in the market.

3.) The losses on the CDS's are for the most part "unrealized."

4.) Berkshire intends to hold the CDS's until expiration of the contracts. Berkshire thinks that the amount of unrealized CDS losses "in any given quarter or year is usually meaningless," In the CEO's letter, Warren states that "on premium revenues alone, these contracts will prove profitable" that "[o]ur derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little," and that "[Charlie Munger] and I will not be bothered by these swings."

Berkshire's positions that the unrealized, temporary losses on the CDS's will likely not cause the CDS's ultimately to be unprofitable is identical to the position that AIG took on unrealized, temporary losses in its CDS portfolio at the end of Q407:

AIG continues to believe that the unrealized market valuation losses on this super senior credit default swap portfolio are not indicative of the losses AIGFP may realize over time. Under the terms of these credit derivatives, losses to AIG would result from the credit impairment of any bonds AIG would acquire in satisfying its swap obligations. Based upon its most current analyses, AIG believes that any credit impairment losses realized over time by AIGFP will not be material to AIG’s consolidated financial condition, although it is possible that realized losses could be material to AIG’s consolidated results of operations for an individual reporting period. Except to the extent of any such realized credit impairment losses, AIG expects AIGFP’s unrealized market valuation losses to reverse over the remaining life of the super senior credit default swap portfolio.

AIG's stock price was punished brutally when these valuation losses on its CDS portfolio were disclosed. The losses even moved AIG CEO Martion Sullivan to request that regulators modify fair value accounting rules:

The American International Group (NYSE:AIG) is urging regulators to change controversial accounting rules on asset valuations to stem the tide of writedowns that have wreaked havoc on Wall Street. The US insurer, which this month recorded a record quarterly loss after an $11bn mortgage-related writedown, is the first company publicly to air a proposal to move away from "fair value" accounting. … Martin Sullivan, AIG's chief executive, told the Financial Times that "mark-to-market" rules forced companies to recognise losses even when they had no intention of selling assets at the current prices. He said the practice created a vicious circle whereby companies recorded huge losses, lost investors' confidence and were then forced to raise funds at unfavourable prices. "This is not a criticism of fair value accounting. I just think it has had unintended consequences in these uncharted waters," he said.

So, even Berkshire Hathaway cannot escape the pernicious effects of fair value accounting. One wonders whether shares of Berkshire will suffer the same fate as those of AIG. I find it baffling that no one at the Omaha annual "Woodstock for Capitalists" did not ask Warren what he thinks of fair value and mark-to-market accounting.