Irrational CDS pricing at Berkshire Hathaway
Irrational CDS pricing at Berkshire Hathaway
Throwing the baby out with the sub-prime bathwater
Business Standard: Immelt meets Buffett in market roiled by credit swaps
Warren Buffett and Jeffrey Immelt are among a handful of chief executive officers whose companies are rated AAA. Yet Buffett’s Berkshire Hathaway Inc and Immelt’s General Electric Co are being treated like junk in the market for credit-default swaps. Contracts that protect investors against a default on bonds of Omaha, Nebraska-based Berkshire, which has $25.5 billion in cash, cost as much as those of KB Home, the homebuilder that lost money for seven consecutive quarters.
Recently, it was reported that credit default swaps for debt guaranteed by Berkshire Hathaway was trading at 5%, meaning to insure $1 million of debt it would cost $50,000 per year. This is the same level as homebuilder KB Home.
I am assuming that the debt in question is that issued by Berkshire Hathaway Finance Corporation (“BHFC”). BHFC issues notes exclusively to finance consumer installment loans in its Clayton Homes manufactured homes business. As of December 31, 2008, there was $10.8 billion outstanding. This debt is guaranteed by Berkshire Hathway Corporation.
I am really struggling to understand the rationality of such pricing.
First, a little background. Clayton Homes is the market leader in low-cost, pre-fabricated manufactured homes. This is a market that has shrunk significantly. In 1998, there were about about 373k pre-fabricated homes sold. Last year, that number was only 82k. Clayton Homes dominates this market, with a 34% market share.
Besides its market leadership position, another interesting aspect of the manufactured homes business is its financing business. Like any other large ticket item business, like homes and cars, there is the financing side of the business, i.e. mortgages and auto loans, respectively. Berkshire Hathaway acquired this business in 2003, attracted by the combination of Clayton’s leadership in the space and financing operations. In fact, one might say this is more a financial services business than a homebuilder; indeed, it is classified as such in Berkshire Hathaway’s financial reporting.
It is clear that in today’s environment, financing businesses are facing headwinds. For Clayton, this is compounded by the fact that the typical buyer of these $40-50k homes are lower income households with approximately one-third of them sub-prime (FICO scores <620). So putting my devil’s advocate hat on, perhaps investors are looking at debt that is effectively issued for a sub-prime financing business. Based on that, I am not surprised that there is interest in insurance to protect themselves. This is compounded by the fact that the CDS market on BHFC notes (not to mention the put market on Berkshire shares) is very thinly traded, and I can see why pricing can get out of control.
That said, at the end of the day, whomever is purchasing insurance at these rates is making a horrible investment decision.
Firstly, Clayton’s underwriting standards have been very good – you can see some qualitative discussion on page 11 in Berkshire’s annual report. Even though the typical customer is low income with lower FICO scores, delinquency rates increased only slightly in 2008 (3.6% compared to 2.9% in 2006), during a time when the delinquency or foreclosure rates on mortgages is upwards of 12%. That is statistically significant evidence of strong underwriting standards.
Secondly, Clayton has matched these loans ($13.9 billion), which appear to be performing relatively well, against this $10.8 billion in BHFC paper. Clearly the economic environment is not good for the pre-fabricated homes industry, but you also have to realize that the market has been bad for Clayton for the past 11 years, with unit volume shrinking to less than 25% of 1998 levels. Yet Clayton continues to be a profitable operation, largely because it is pretty much the last man standing. Clayton generated operating income of $206 million last year, and this after paying $92 million to Berkshire to use its Triple-A guarantee.
You can make a credible argument that Clayton would in normal times not even need Berkshire’s support to finance itself. In fact, before Berkshire Hathaway acquired them, that is how they operated. Being part of Berkshire just made access to financing easier and helped accelerate the most profitable part of its business.
Last and most importantly, BHFC paper is ultimately guaranteed by Berkshire Hathaway, so that’s what the credit decision should largely be based on. So the credit analysis should ultimately fall back upon your belief in the credit quality of Berkshire Hathaway.
From my perspective, the chances of Berkshire Hathaway defaulting are infinitesimally low. I will post later about why I believe that to be the case, but it is going to be based on a deep analysis of the companies various operating businesses, investments and derivative bets.
I would love to find a way to take the other side of that CDS trade. I would love to hear if anyone has any good ideas.
This was originally published in a personal blog in March 2009.