Incite: Berkshire Hathaway's option valuation lesson
Wednesday, 27 January 2010

By Thomas Courtright

A comment letter from the Securities and Exchange Commission regarding the valuation of complex options contracts by Berkshire Hathaway, widely regarded by investors as one of the smartest insurance companies, offers an interesting lesson in mark-to-market reporting. In an exchange of correspondence in June, the SEC questioned Berkshire's volatility assumptions when valuing equity options contracts. The situation illustrates the financial reporting challenging posed by mark-to-market rules. The lesson for us all is to take extreme care and prudence in performing these valuations.

In a nutshell, Berkshire Hathaway entered into and continued to hold equity index put options on four stock market indexes of different countries that were set to expire far into the future in 2019 and 2028. These contracts are essentially insurance, or hedges, in case the indexes lose value, theoretically allowing Berkshire's holdings of equity investments in these countries to be somewhat protected against declines in the equity indexes. While Berkshire is not required to settle any gains or losses or make any payments related to these put option contracts until well into the future, they are still required to value or "mark to market" the contracts for financial reporting purposes and include the "paper" gain or loss in their financial results.

In a letter to Berkshire CFO Mark Hamburg, the SEC's Joel Parker asked Hamburg to "please disclose how you determine weighted average volatility. In addition, tell us why the 2008 weighted average volatility was relatively unchanged from 2007 in light of the market conditions experienced in 2008." In the SEC's view, Berkshire's disclosures related to option volatility analyses and the inputs they considered were insufficient. Specifically, the SEC questioned how volatility inputs into the option models Berkshire used could possibly remain unchanged from the end of 2007 to the end of 2008. A low volatility input would lead to a relatively understated valuation of the options.

Hamberg's response:

"The weighted average volatility was based on the volatility input for each equity index put option contract weighted by the notional value of each equity index put option contract relative to the aggregate notional value of all equity index put option contracts. The volatility input for each equity index put option contract was based upon the implied volatility at the inception of each equity index put option contract.

We recognize that the index values of the four indexes declined between 30 percent and 45 percent at December 31, 2008 as compared to the prior year-end index values. Even though these short-term declines are in excess of our volatility inputs, we continue to believe that our volatility inputs are reasonable given the long-term nature of our equity index put option contracts which have contract expiration dates between 2019 and 2028."

Berkshire Hathaway is an insurance company and is accustomed to the framework of actuarial gains and losses while never losing sight of long-term investment value. Hamburg's comments illustrated that Berkshire understood exactly what it owned and why. This is not a case of some complex derivative instrument that is difficult to understand or one that requires increasingly complex modeling. Instead, what Berkshire Hathaway is dealing with is a mark-to-market exercise. Berkshire describes on page 41 of their 10 K that these are simply mark-to-market valuations on contracts that do not expire with cash settlements until one to two decades into the future and represent "non-cash changes in the fair value of credit default and equity index put option contracts. Changes in the fair values of these contracts are reflected in earnings and can be significant, 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 these contracts and the volatile nature of equity and credit markets over short periods of time. Therefore, the ultimate amount of cash basis gains or losses may not be known for years."

However, in practice, volatility is a surrogate for price in the options market. While Berkshire may believe their volatility inputs are reasonable given the long-term nature of the contracts, they essentially are saying the price to hedge at the end of 2008 remained unchanged, holding all other option variables constant. This is an interesting conclusion from an insurance company when market participants know that hedge protection is always more expensive after market displacements, even if its value or price might revert back to its prior value after a few years.

Valuing these contracts often requires a measure called implied volatility which is not readily observable for long-term option contracts of three or more years since option securities of this duration are relatively rare securities. But clearly, if implied volatility measures for liquid contracts of puts were observable, they would likely be considerably higher than at the end of 2007.

Why did Berkshire assume a lower volatility input? In a mark-to-market exercise, a low volatility input results in a relatively low fair value holding all else equal. This could be deemed to be conservative and relatively lower impact on EPS. Berkshire may have preferred not to exacerbate earnings moves when there was no fundamental long-term merit for such moves.

When Hamberg says that their volatility conclusion remains reasonable, he may be saying that while the expected pattern of volatility has shifted considerably in the short term, the aggregate long-term result has not really changed. Berkshire watchers may conclude that long-term volatility expectations must necessarily be well below the volatility measures concluded at the inception of the contracts such that the result over the long-term would remain relatively unchanged. This may be what prompted the SEC to make further inquiries into volatility details. My colleague, Summer Parrish, an expert in the valuation of options, believes this uncovers an interesting issue and potential question for the SEC to address. How can registrants weigh short-term market evidence, such as implied volatility measures, against long-term measures when attempting to support long-term security value? What maturity ranges would allow short-term measures to become relatively less appropriate for consideration and long-term securities to be exempt from short-term volatility evidence? Can a maturity limit be defined for securities legitimately considered "long-term" for the purpose of mark-to-market accounting? These appear to be issues that have been brought to the surface but remain unanswered.

But the mark-to-market rules do not rely on Berkshire's long-term expectations. Instead, they require carefully applied valuation methodology consistently applied to market evidence. In performing volatility analysis, a thorough examination of all available volatility evidence is required. Multiple approaches should be considered including simulation of Monte Carlo models as well as alternative frameworks that consider both a term structure of interest rates and term structure of volatility to help support volatility assumptions over both the near term as well as the long.

What this means for all of us is that financial reporting standards are evolving to a higher standard every year. Companies, boards of directors, and management will need to pay increasing attention to the details. In an exceptional environment like this one, exceptional care and prudence are required. Ultimately the SEC and FASB are the regulatory authorities. Even Berkshire Hathaway needed to spend more time examining this valuation issue up front if it was interested in avoiding public SEC scrutiny. By failing to do so, the company faced additional time for regulatory compliance on the back end.

Thomas Courtright is senior vice president of Valuation Research Corporation and an expert in the valuation of financial instruments, including stock options, for financial reporting purposes.

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