Goldman Sachs Plans to Redeem Berkshire Hathaway’s Investment

“Goldman Sachs has the right to call our preferred on 30 days notice, but has been held back by the Federal Reserve (bless it!), which unfortunately will likely give Goldman the green light before long.”

— Warren Buffett, 2010 Letter to shareholders dated February 26, 2011

Goldman Sachs has announced that the Federal Reserve has granted approval for the company to redeem Berkshire Hathaway’s $5 billion investment in Goldman’s 10% cumulative perpetual preferred stock.  The investment was made on October 1, 2008 at the height of the financial crisis.

Goldman Sachs will have to pay Berkshire a 10% premium and is required to provide 30 days notice of its intent to redeem.  As a result, the redemption will take place on April 18, 2011.  Berkshire Hathaway will retain the Goldman Sachs warrants that were issued as part of the deal. Berkshire has the right to purchase 43,478,260 shares of Goldman Sachs at $115 per share.  The warrants expire on October 1, 2013.  Based on Goldman’s closing price of $159.96 today, Berkshire would hypothetically earn a profit of nearly $2 billion if the warrants were exercised today and the shares sold at the closing price.

In Mr. Buffett’s recent letter to shareholders, he predicted that both Goldman Sachs and General Electric would redeem the preferred stock investments Berkshire made during the darkest days of the financial crisis.  General Electric is contractually prevented from initiating the redemption until October 2011.  Berkshire’s highly successful investment in Swiss Re was recently redeemed.  Mr. Buffett warned that it would be difficult for Berkshire to replace the lucrative income streams from these investments which were made on very favorable terms during the financial crisis.

Mr. Buffett has stated that he is on the hunt for acquisitions due to the need to allocate Berkshire’s large cash position as well as the cash that will be coming in due to repayment of the financial crisis era investments.  On Monday, March 14, Berkshire Hathaway announced plans to acquire Lubrizol in a deal worth $9.7 billion.

The Rational Walk’s recently published report, Berkshire Hathaway:  In Search of the “Buffett Premium” contains a section that covers Berkshire’s financial crisis investments in more detail.  That section of the report is included as part of the free sample which may be downloaded in PDF format or viewed in Scribd format through the viewer the appears below.  RSS Feed readers may view the file on Scribd by clicking on the link.

In Search of the “Buffett Premium” — Free Sample

Disclosure: Long Berkshire Hathaway

Goldman’s Problems Continue with Threat of FCIC Derivatives Audit

Despite paying the largest penalty ever assessed against a financial firm by the Securities and Exchange Commission, Goldman Sachs is still an attractive target for government panels investigating the financial crisis. Goldman agreed to pay a $550 million settlement on July 15 in connection with the Abacus case in which the SEC alleged that Goldman failed to disclose key information regarding the portfolio selection process.  Today, the Financial Times reported that Goldman is facing a separate inquiry by the Financial Crisis Inquiry Commission (FCIC) regarding the company’s use of derivatives.

FCIC Chairman Phil Angelides believes that Goldman Sachs is not being honest regarding the manner in which the company tracks revenues generated from derivatives trading.  At a recent hearing, two Goldman executives told the FCIC panel that the bank does not break out trading revenue generated strictly from derivatives:

They maintained that such information would give little insight into the bank’s trading risks as many trades involving a derivative contract also include an offsetting cash security. For instance, Goldman might buy a credit default swap to hedge against the possible default of a company where the bank also has a position in its debt. Tracking the revenue of one slice of a trade would ignore whatever gains or losses were booked on the other side, the bank said.

This seems entirely reasonable given the manner in which derivatives are used by large financial institutions.  The FCIC is threatening to send auditors to examine the raw data at Goldman and it is possible that programmers could extract only derivatives trades from the vast databases that the firm keeps to track trading activity.  However, without looking at such trades in the overall context of what they were intended to accomplish, the exercise would appear to be more likely to confuse the issue than to provide any insight for investigators.

It is unclear whether the FCIC understands how financial institutions use derivatives in modern markets:

Mr Angelides said he remained skeptical that Goldman did not have the derivatives information, given the bank’s reputation for risk management and its discipline in marking the value of every position daily. “It’s not credible that that’s a black hole,” Mr Angelides said. “It defies logic that these institutions have no clue of how much money they are making or losing from these derivatives.”

Goldman Sachs is known for risk management and it would in fact “defy logic” if the bank had no mechanisms in place to measure risk.  However, looking at a part of a transaction made up of a derivatives position while failing to examine offsetting transactions does not constitute “risk management”.  Rather, it seems to be a political exercise meant to vilify a financial instrument rather than a credible attempt to examine the overall risks being taken by financial institutions in a more holistic manner.

It is unclear whether government officials understand the nature of how derivatives are actually used and what risks emanate from such use, or if they do understand the issues but are attempting to make some political point by falsely isolating the impact of derivatives books from broader transactions.  In either case, loud announcements threatening audits will not help reassure markets regarding the stability of the financial system.

Disclosure:  The author has no direct position in Goldman Sachs but owns shares of Berkshire Hathaway, a large investor in Goldman Sachs securities.

Buffett Gives Goldman Sachs Another Vote of Confidence

Berkshire Hathaway’s investment in Goldman Sachs at the height of the financial crisis represented a major vote of confidence that enabled Goldman to raise additional equity from investors.  The September 2008 deal involved $5 billion in Goldman Sachs perpetual preferred stock along with five year warrants to purchase approximately 43.5 million shares of Goldman common stock at $115 per share.  The preferred stock carries a dividend rate of 10% and is callable at any time at a 10% premium.  Despite the recent drop in Goldman Sachs common stock, Berkshire’s warrants remain in the money. While Goldman could almost surely refinance Berkshire’s $5 billion preferred stock investment at a lower rate, having Warren Buffett’s endorsement in the current environment may be priceless.

Confidence Unshaken

In an interview with Bloomberg, Berkshire Hathaway Director Thomas Murphy states that Mr. Buffett is “not concerned with the investment at all” and continues to have great confidence in Goldman.  Mr. Murphy spoke to Mr. Buffett after the SEC charges against Goldman were announced on April 16.  This follows an interview with Berkshire Hathaway Director Ron Olson last week prior to the SEC charges in which Mr. Olson stated that Berkshire’s investment was a bet on Goldman’s integrity.

Goldman’s Response to SEC Complaint

Over the past week, Goldman’s response to the SEC charges has  more clearly taken shape.  Last week, we provided a summary of the SEC charges and recommended that Goldman take quick action to address the charges and to hold individual employees accountable.  The most serious charge involves the claim that Goldman led ACA to believe that the Paulson & Co. hedge fund was taking a long position on the synthetic CDO deal known as Abacus.  The SEC did not charge Paulson with any wrongdoing.

Earlier this week, The Wall Street Journal reported that Paolo Pellegrini, one of the top executives at Paulson & Co., told SEC investigators that he personally informed ACA that Paulson had a bearish outlook for the CDO.  The SEC complaint made no mention of Mr. Pellegrini’s statement.  The SEC has indicated that a full accounting of the investigation will occur “at the appropriate time”.

Fraud or Poor Judgment?

Whether the charges against Goldman amount to fraud largely rests on the charge that the firm misrepresented the nature of Paulson’s role in the transaction.  As Mr. Murphy stated in the Bloomberg interview, all of the major players involved in the transaction were very sophisticated buyers and sellers.  ACA obviously knew about Paulson’s involvement in selecting the collateral for the CDO.  If Goldman did not lead ACA to believe that Paulson was long, as the SEC complaint alleges, the government’s case will be much weaker.

The conduct of Fabrice Tourre, including several embarrassing emails, indicates the poor judgment and immaturity of a junior level employee who apparently had a major role in the transaction.  In a session sure to produce some political fireworks, Mr. Tourre is scheduled to testify before Congress next week along with Goldman CEO Lloyd Blankfein and others from the firm.

It is likely that Mr. Buffett has been briefed on the situation by Goldman’s management.  While Berkshire has an obvious economic stake in the outcome of the investigation, the potential impact to Berkshire’s reputation would be more significant if Mr. Buffett’s support ends up being misplaced.  Berkshire shareholders should have some confidence that the situation is not as dire as indicated by the SEC charges if Mr. Buffett is willing to publicly support Goldman’s management at this time.

Disclosure:  The author owns shares of Berkshire Hathaway.  No position in Goldman Sachs.