By now you have heard that Warren Buffett’s bets on GE, Goldman, and Swiss Re and his derivatives positions have earned him a downgrade from Fitch Rating Agency. Below is the Fitch statement. I have highlighted the key sections:
Fitch Ratings has downgraded the Issuer Default Rating (IDR) and senior unsecured debt ratings of Berkshire Hathaway Inc. (NYSE:BRK/A) as follows:
–IDR to ‘AA+’ from ‘AAA’;
–Senior unsecured debt to ‘AA’ from ‘AAA’.
Fitch has concurrently affirmed its ‘AAA’ Insurer Financial Strength (IFS) ratings on BRK’s insurance and reinsurance subsidiaries. The Rating Outlook for all entities is Negative. See full list of rating actions below.
Today’s actions are part of a broader review of insurance and financial services company ratings being conducted by Fitch, which includes taking a fresh look at various risk factors and criteria application in light of the current stressful economic environment. Related to this ongoing exercise, which has resulted in numerous insurance and other financial services sector downgrades in recent weeks, Fitch believes that ‘AAA’ ratings are not appropriate at the holding company level for financial-oriented enterprises given significant market volatility and correlation of risks under stress, recently observed throughout the global economy.
With respect to BRK, Fitch views the company’s potential earnings and capital volatility derived from its large, unhedged market exposures as inconsistent with the stability required at the ‘AAA’ level. Such exposures include large, concentrated equity investments, as well as exposure to the equity and credit markets through various derivative contracts. Fitch views BRK’s investments in a wide variety of retail, service and manufacturing companies as mitigating this exposure somewhat, but Fitch does not view BRK’s degree of diversification as sufficient to offset these concerns at the ‘AAA’ level.
The downgrade also recognizes that even the most senior obligations at the holding company level are deeply subordinated to policyholder obligations at the regulated insurance and reinsurance company subsidiaries. Fitch notes this point is not new, but rather reflects Fitch’s view on appropriate weighting given to this risk in the current environment and at the current rating level.
BRK’s ratings also continue to reflect Fitch long-standing concerns with respect to ‘key man’ risk in the form of the company’s chairman, Warren Buffett. Fitch views this risk as unrelated to Mr. Buffet’s age, but rather Fitch’s belief that BRK’s record of outstanding long-term investment results and the company’s ability to identify and purchase attractive operating companies is intimately tied to Mr. Buffett. In current application of its criteria, Fitch does not view this concentration as consistent with an ‘AAA’ rating.
The ‘AAA’ IFS ratings of BRK’s insurance subsidiaries continue to reflect their strong capitalization and competitive positions, and underlying underwriting results. Fitch notes that at their current levels, BRK’s IFS, IDR and senior unsecured ratings continue to be among the highest in Fitch’s rating universe.
Fitch’s current ratings on BRK assume that the company is likely to continue to aggressively deploy its cash and capital as the potential for ongoing difficult economic and capital market conditions persists and companies look for investors with strong balance sheets to provide funding. Fitch would view this deployment as consistent with BRK’s long-standing opportunistic investment style although it adds an element of fluidity to BRK’s profile. Over the last six months BRK has agreed to purchase CHF3 billion of 12% preferred shares in Swiss Re, and has purchased $5 billion of 10% preferred shares in Goldman Sachs, and $3 billion of 10% preferred shares in General Electric. Additionally, in early 2008, BRK formed a financial guarantor to insure tax exempt bonds issued by states, cities, and other local entities and by year-end (YE) 2008 the company had written $595 million of financial guaranty premiums.
In 2008, BRK’s total shareholders equity declined by 9.5% to $109 billion. Major components of the change in equity included a $15 billion (after-tax) decline in BRK’s net unrealized gain on investment securities, largely tied to declining equity markets, partially offset by $5 billion of net income. Net earnings were down from over $13 billion in 2007 and represent a six-year low for the firm.
BRK’s 2008 earnings also included $3.3 billion (after-tax) of non-cash mark-to-market losses on equity index put contracts the company has written with a notional value of $37 billion as of YE 2008. These contracts include equity index put option contracts on four indexes, including three indexes outside of the United States. BRK has also written credit default swap (CDS) contracts on various high yield indexes, state and municipal bond issuers, and single name corporate issuers with notional amounts of $30 billion as of YE 2008.
While the contracts’ recent mark-to-market losses are large, the agency believes that the ultimate economic effects, while uncertain, are likely to be significantly less than indicated by the marks. Favorably, the equity index put contracts were generally written with strike prices equal to the then current index value, had a weighted average maturity of 13.5 years at YE 2008, and are exercisable only at maturity. The CDS contracts appear to be well-managed with reasonable contract and per issuer limits. Additionally, few of the contracts have collateral positing requirements. At YE 2008 BRK had posted $550 million of collateral related to these contracts, a small amount for a company with BRK’s liquidity profile.
BRK uses a reasonable amount of financial leverage in its capital structure and at YE 2008 its consolidated debt-to-total capital ratio was 25%. BRK’s consolidated debt is derived from three sources; debt issued or guaranteed by the holding company, debt issued by the company’s finance and financial products subsidiaries, and debt issued by the company’s utilities and energy subsidiaries.
When evaluating BRK’s financial leverage at the parent level, Fitch generally excludes debt issued by BRK’s utilities and energy subsidiaries from its analysis since the agency believes that these subsidiaries have the ability and intent to fund this debt without parent support. In contrast, Fitch includes debt issued by BRK’s finance company subsidiaries that is guaranteed by BRK. Much of this debt is issued to fund loans and receivables, with these assets ‘matched’ against the debt balances. Given the current difficult economic environment and pressure on asset values, Fitch believes “matched” debt poses additional risks to those posed in the past.
The Negative Outlook reflects uncertainty surrounding the ultimate effect of the current financial market conditions on BRK and its insurance company subsidiaries. These uncertainties include potential further equity market declines and the affect they would have on BRK’s vast equity portfolio and capitalization, as well as the adverse effect of general economic conditions which are likely to pressure BRK’s earnings over the next 12-to-18 months.
For its current review, Fitch received from BRK’s management certain non-public information regarding BRK’s derivative exposures. However, Fitch does not regularly meet with BRK management, and does not believe the extent of interaction meets that required for Fitch to consider its ratings on BRK and its subsidiaries to be fully interactive. Fitch’s ratings on General Reinsurance Corporation (GenRe) and its direct and indirect subsidiaries, is the result of an interactive process between GenRe and Fitch in which Fitch regularly meets with Gen Re management and has received non-public information from the company.
Fitch has taken the following rating actions:
Berkshire Hathaway, Inc.
–IDR downgraded to ‘AA+’ from ‘AAA’.
Berkshire Hathaway Finance Corporation (BHFC)
–IDR rated ‘AA+’;
–$1.5 billion 5.11875% notes due Jan. 11, 2011 downgraded to ‘AA’ from ‘AAA’;
–$1 billion 4.6% notes due May 15, 2013 downgraded to ‘AA’ from ‘AAA’;
–$1 billion 5% notes due Aug. 15, 2013 downgraded to ‘AA’ from ‘AAA’;
–$1.5 billion 4.125% notes due Jan. 15, 2010 downgraded to ‘AA’ from ‘AAA’;
–$500 million 4.20% notes due Dec. 15, 2010 downgraded to ‘AA’; from ‘AAA’;
–$700 million 4.75% notes due May 15, 2012 downgraded to ‘AA’ from ‘AAA’;
–$750 million 5.125% notes due Sept. 15, 2012 downgraded to ‘AA’ from ‘AAA’;
–$500 million 4.5% notes due Jan. 1, 2013 downgraded to ‘AA’ from ‘AAA’;
–$950 million 4.625% notes due Oct. 15, 2013 downgraded to ‘AA’ from ‘AAA’;
–$400 million 5.10% notes due July 15, 2014 downgraded to ‘AA’ from ‘AAA’;
–$1 billion 4.85% notes due Jan. 15, 2015 downgraded to ‘AA’ from ‘AAA’.
–IDR downgraded to ‘AA+’ from ‘AAA’;
–$150 million 7.40% senior notes due July 15, 2023 downgraded to ‘AA’ from ‘AAA’.
General Re Corporation
–IDR downgraded to ‘AA+’ from ‘AAA’;
–$150 million 9% senior notes due Sept. 12, 2009 downgraded to ‘AA’ from ‘AA+’;
–Short-term IDR affirmed at ‘F1+’;
–$500 million commercial paper program affirmed at ‘F1+’.
Fitch has affirmed the ‘AAA’ IFS ratings of the following companies with a Negative Rating Outlook:
–Government Employers Insurance Company;
–General Reinsurance Corporation;
–General Star Indemnity Company;
–National Reinsurance Corporation;
–General Star National Insurance Company;
–Genesis Insurance Company;
–Genesis Indemnity Insurance Co.;
–Fairfield Insurance Company;
–National Indemnity Company;
–Columbia Insurance Company;
–National Fire and Marine Insurance Company;
–National Liability and Fire Insurance Company;
–National Indemnity Company of the South;
–National Indemnity Company of Mid-America;
–Wesco Financial Insurance Company.
Fitch Downgrades Berkshire Hathaway to ‘AA’; Affirms ‘AAA’ IFS; Outlook Negative – Business Wire