BLOOMBERG: Immelt Meets Buffett in Market Inflamed by Credit-Default Swaps

By Shannon D. Harrington

March 6 (Bloomberg) -- Warren Buffett’s Berkshire Hathaway Inc. and Jeffrey Immelt’s General Electric Co. are being battered in the market for credit-default swaps, treating both AAA companies like junk.

Investors are paying as much for contracts that protect against a default on the bonds of Omaha, Nebraska-based Berkshire, which has $25.5 billion in cash, as for KB Home, the homebuilder that lost money for seven consecutive quarters. The cost of credit-default swaps on the finance arm of GE and its $45 billion in cash is about the same as for building materials- maker Louisiana-Pacific Corp., which posted nine straight quarterly losses.

Trading in credit derivatives proves investors believe no borrower is immune from a seizure in credit markets that led to the U.S. government’s takeover of insurer American International Group Inc. and the collapse of investment bank Lehman Brothers Holdings Inc. Like those companies, Berkshire and GE relied on high credit ratings to generate profit and win new business.

“The market is tarring them with a similar brush in that these guys likely used their AAA ratings to achieve a very low funding on bets that you and I may have not otherwise have taken,” said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California.

Traders are increasing bets against GE because the Fairfield, Connecticut-based company’s finance arm may need to post as much as $12 billion in collateral if long-term ratings are cut to the single-A level and short-term ratings fall below the top A1/P-1 category, CreditSights Inc. analyst Richard Hofmann in London estimated in a research note this week. He based the analysis on a review of GE’s regulatory filings.

Highest Ratings

Berkshire and GE have the highest ratings from both Moody’s Investors Service and Standard & Poor’s. Berkshire said Feb. 28 that fourth-quarter net income fell 96 percent to $117 million from $2.95 billion in the same period a year earlier. GE just posted its third-highest annual profit and is the biggest maker of jet engines and power turbines.

Moody’s judges the debt obligations of companies with its Aaa rating to “be of the highest quality, with minimal risk.” S&P says its AAA credit rating means an “obligor’s capacity to meet its financial commitment on the obligation is extremely strong.”

Moody’s said Jan. 27 that it’s evaluating whether to lower GE’s rating, a review that typically takes about 90 days. GE cut its dividend Feb. 27 for the first time since 1938 to save $9 billion a year. Bonds ranked below Baa3 by Moody’s or less than BBB- by S&P are considered high-yield, high-risk, or junk.

Loss Hedge

Credit-default swaps are used to hedge against losses or to speculate on a company’s ability to repay its debt. They pay the buyer face value if a borrower defaults in exchange for the underlying securities or the cash equivalent. Prices for the contracts rise when perceptions of credit quality decline.

Trading in the unregulated $27 trillion market has come under scrutiny by regulators and company executives, who blame bets made in the market for amplifying the credit crisis. Richard Fuld, Lehman’s chief executive officer, in Oct. 6 congressional testimony blamed his firm’s September collapse on “destabilizing factors” including the soaring price of default protection on the investment bank.

Regulators in the U.S. and Europe are pushing dealers to develop clearinghouses that would act as the buyer to every seller and seller to every buyer, reducing the risk of a counterparty defaulting on a transaction.

Upfront Payments

Sellers of credit-default swaps tied to the debt of General Electric Capital Corp. for five years yesterday demanded 16.5 percent upfront, in addition to 5 percent a year, according to broker Phoenix Partners Group. That means it costs $1.65 million initially and $500,000 annually to protect $10 million of obligations. The cost was $446,000 a year two weeks ago.

Swaps on Nashville-based Louisiana-Pacific, rated BB by S&P, or 12 steps lower than GE Capital, trade at 17.75 percent upfront, according to CMA DataVision.

GE Chief Financial Officer Keith Sherin said in an interview on the GE-owned CNBC television network yesterday that the surge in credit-default swaps on his company’s finance unit “is overdone” and worsened by below-average trading volume.

“We looked at the actual CDS trades on Monday and Tuesday,” he said. “It was a total of $35 million over the two-day period. Normally, it’s $100 million a day. Was that really market fundamentals or was it just some sort of disruption based on very narrow trades in a volatile time?”

Shrinking Finance

Immelt, GE’s chief executive officer, said he intends to shrink the finance arm to 30 percent of total earnings this year from about half in 2007. GE’s profit from continuing operations was $18.1 billion last year as finance made $8.6 billion. The company projected the unit will earn $5 billion this year.

GE has still lost about $266 billion in market value in 12 months, while Berkshire has lost $120.3 billion since peaking at $231.06 billion on Dec. 10, 2007. GE closed at $6.66 yesterday in New York Stock Exchange composite trading, while Berkshire finished at $72,400.

Swaps on Berkshire have soared 2.26 percentage points the past two weeks to 5.35 percent a year, CMA data show. That compares with 4.9 percent annually for Los Angeles-based KB Home.

Buffett, who is Berkshire’s chairman and CEO, said in his annual letter to shareholders Feb. 28 that companies such as his that haven’t taken government bailouts or don’t have access to state funding are effectively being penalized by markets. More than 500 banks, insurers and credit-card companies applied for capital from the Troubled Asset Relief Program and the government has distributed almost $300 billion.

Buffett’s Complaint

“Funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be,” he wrote. “Government is determining the ‘haves’ and ‘have-nots’.” Buffett didn’t immediately respond to a request for comment left with assistant Carrie Kizer.

Berkshire in 2008 started writing credit-default swaps on individual companies, with contracts guaranteeing $4 billion of debt from 42 borrowers, Buffett said in the letter. The company is unlikely to expand the position because “most buyers of this protection now insist that the seller post collateral, and we will not enter into such an arrangement,” he said.

Buffett has struck deals with firms that Berkshire hasn’t identified to protect them against declines in four equity indexes and guarantees on indexes of non-investment grade debtors that require the company to pay out when there’s a default.

Housing Key

Because an average of just 1,550 Berkshire shares are traded on public exchanges, it’s difficult to borrow the stock to bet against the company through short sales. So, speculators may be buying credit-default swaps to hedge against equity losses, said Backshall of Credit Derivatives Research.

Until the plunge in the housing market is stemmed and asset prices stabilize, finance companies such as GE Capital will continue to be penalized, said Gregory Habeeb, who manages $7.5 billion of fixed-income assets at Calvert Asset Management Co. in Bethesda, Maryland.

“They need some improvement in fundamentals that we’re just not getting,” Habeeb said. Housing “continues to create the drop in asset values that’s choking everyone,” he said.

The surge in GE’s credit-default swaps may also be related to collateralized debt obligations that bet on companies’ creditworthiness. The CDOs often held credit-default swaps tied to GE because they paid higher premiums relative to the company’s ratings, boosting returns, said Backshall. Now, the dealers who sold the CDOs must hedge their exposure by buying protection, pushing prices of the contracts higher.

Among the so-called synthetic CDOs ranked by Fitch Ratings, GE Capital is the company most often bet on, according to data compiled by the firm.

A lot of traders “are in a position of where it’s sort of hedge or lose your job,” Backshall said. When GE credit swaps soared to as high as 20 percent upfront yesterday, “that was likely driven just by a desk deciding to desperately hedge,” he said, “rather than a real belief” that the company had a high risk of defaulting.

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