Hedging a Currency Disaster
Trying to estimate Berkshire's profits from its
foreign exchange transactions is difficult because we do not know
exactly which currencies Buffett has taken a position in, and
because these are short-term contracts (generally one year or
less—the mix may have changed substantially in the last 12 months).
FOREX in the Fourth Quarter
In last year's annual report there is an
interesting table on page 67, "Estimated Fair Value Assuming a
Hypothetical Percentage Increase (Decrease) in the Value of Foreign
Currencies Versus the Dollar." This table appears to be Warren's
attempt to help us estimate gain or loss in the currency position.
The table says that a 10% drop in the dollar would leave Berkshire
with a gain of $1.235 billion. At the time there was about $11
billion in notional value in the FOREX positions, according to the
third quarter report these positions now amount to $20 billion. This
is an increase of 81%. If we multiply the $1.235 billion times 81%,
a 10% percent drop in the dollar would bring Berkshire $2.235
billion or a $223 million gain for each 1% loss by the dollar.
Depending on the currency index that you use,
the dollar has fallen somewhere between 5.5% and 7.1%. So far in the
fourth quarter, using the estimate from the annual report,
Berkshire's gain is probably somewhere between $1.4 billion and $1.7
billion before taxes, YTD.
The interesting thing is that most of that move
has come since the dollar broke support in early October. Since
then, it has been falling at the rate of about 1% every week and a
half. While the currency's position has had only a small impact on
Berkshire's earnings so far, the impact in the fourth quarter will
be much larger if the present trends continue. As we would expect
the rational and wondrously efficient Mr. Market does not seem to
have a clue.
Berkshire as a Currency Hedge
Buffett's recent move into Foreign Exchange is
remarkable for many reasons, first because of its size, which, at
last report, amounted to $20-some billion in notational value. To
say that this is a large bet is obviously an understatement. More
remarkable still is the fact that this is the latest in a series of
large macro bets: the purchase of S&P puts, junk bonds purchases,
and fixed income sales. These actions are so wonderfully out of
character for the world's greatest value investor, as to suggest
that by some mysterious process Kiewit Plaza had been magically
transported to Lower Manhattan and George Soros has taken position
of the oracle's body.
Almost as remarkable as the nature of these transactions is the size of the profits they have generated. While it is way too early to judge the outcome of the FOREX positions, they have the potential to dwarf his earlier adventures. Buffett himself has characterized the transactions as a hedge for Berkshires wholly owned businesses against the decline of the dollar. But for Its shareholders, Berkshire itself has become a hedge against the sort of disaster that could result from the sudden collapse of the dollar. By this I mean that if the dollar where to suffer a sudden catastrophic decline, the result might well be a sharp increase in interest rates and subsequent decline in the stock market. Berkshire's intrinsic value would increase not just because of huge profits in its FOREX positions but if the market decline is prolonged and sharp enough Berkshire would find its huge cash pile much more valuable, because of the opportunity to swallow large elephants whole.
So far the decline of dollar, while accelerating
since the beginning of the forth quarter, has been orderly. but
there is no guaranty that it will stay that way. Most analysts place
the blame for the dollar's decline at the feet of the individual
foreign investors who have lost faith in the dollar, and are
converting their dollar positions into local currencies. It is
important to understand that the dollar has been in a steady decline
for three years and is currently trading more that 30% below were is
was in 2001. One measure of the extent of the over valuation of the
dollar is fact the even after a 20% to 30% decline in the dollar
(depending on which currency index you use) the U. S. trade deficit
is still growing. The main casualty of this decline, so far, is our
equity markets. It appears that some of the foreign capital sucked
in here by the "Great Tech Bubble" has already left the building.
So far, foreign central banks have been
absorbing dollars sold by their locals by buying US Treasury
securities. Evidence of this is the fact that domestic long-term
rates have remained stable as the dollar has fallen; this is so
because of huge purchases of long bonds by these central banks. The
three-year decline has left these foreign central banks with a huge
net loss on US Bonds they have purchased. Yet their purchases have
accelerated as the dollar has declined. This does not seem to me to
be a stable situation, maybe these central banks will continue to
buy our bonds forever, but if they ever decide to cut their losses
and dump their American bonds, the result could be quick and dirty:
a further sharp drop in the value of the dollar and a sudden perhaps
spectacular rise in our long-term interest rates. Interest rates are
basically the price of money, and if our bonds loose their biggest
buyers, we are going to have to pay a lot more to refinance our
debt.
Most international holders of U.S. debt are
currently suffering a negative return (the dollar's decline is
larger than the interest they receive) for the privilege of letting
us use their money, and one wonders how long they will tolerate
this. A story in the Wall Street Journal of December 6, 2004 pointed
out that "if current trends continue the Central Banks of Japan and
China will have upped their dollar reserves from an estimated $1.4
trillion at the end 2004 to about $3 trillion by the close of 2008."
Granted, the foreign central banks have a
different agenda than the individual investor, but "the risk of a
loss due to a drop in the dollar would at that point, far outweigh
any benefit gained from continuing of finance U. S. consumption."The
longer these banks continue to buy and hold US treasuries the more
out of balance the dollar becomes. It is an imbalance that will
eventual have domestic consequences The central bank purchases keep
long-term interest rates in this country artificially low and is
blowing a nice bubble in our real estate market. The bigger this
bubble gets, the more pain there will be when it eventually pops.
Our current accounts deficit says that the
dollar is still way overvalued. I have no idea how or when this
imbalance will correct, but logic would indicate that sooner or
later it will. "If something cannot go on forever, it will stop,"
and the longer these central banks support dollar (and the bond
market) the more likely it is that the eventual correction will be
painful. Buffett has very skillfully placed Berkshire in a position
to benefit from any financial crisis that erupts. In view of this I
think that any investor with positions in US equities should
consider hedging the risks now inherent in domestic equity prices
with a sizable position in Berkshire Hathaway.