Thursday, April 7, 2011

Insider Trading As Art

I cannot tell you how many hedge fund managers will tell you they invest like Warren Buffett.  Making such a claim strikes me as particularly silly.  At best, they invest like Warren Buffett 20 years ago.

Here's a story about why you do not invest like Warren Buffett.

Several years ago, State Farm had to place a massive reinsurance treaty, (that's a contract that pays State Farm after a catastrophic event--insurance for an insurance company,) for the risks of widespread fires following an earthquake in California, for billions of dollars.  The reinsurance brokers told potential counterparties to this contract that Berkshire Hathaway had set the price, and agreed to take a substantial fraction of the risk.  Sounds good, right?  Ajit Jain and Warren Buffett set the price, and you can get in on it too!

But wait!  The contract covered State Farm for something like $4 billion after they lost $2 billion.  And, Berkshire had also provided insurance to State Farm for losing $1 billion after they lost their first $1 billion.  But, no one knew the price paid for that treaty. 

That's when I realized Warren Buffett trades on inside information.  Few people asked anything about the second contract, (called the "lower layer" in reinsurance lingo.)  State Farm could pay Berkshire a fortune on the lower layer to compensate them for setting the price on the massive, higher layer.

At the height of the financial crisis, Buffett bought a preferred equity from Goldman Sachs that he wrote about in his annual shareholder letter.  Sure, he probably thought Goldman stock was cheap and the company could pay its debts.  But, he also knew that with his blessing, the market would have less concern about Goldman, and his actions would contribute to Goldman's success.  Ditto for Swiss Re and General Electric.

Buffett trading with market power--insider information.  You and I don't do that.  You and I don't even contemplate doing that.  Sure, when I trade my incredibly illiquid insurance stocks I worry about moving the price, but I don't change the prospects of the company.

So, why all the hoopla over David Sokol's trading?  How's the guy in line to be the boss supposed to learn to trade like the boss??!!??

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