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The Berkshire-Goldman Connection

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. When the SEC revealed its civil indictment against Goldman Sachs a couple of weeks ago, naturally the Goldman Sachs stock dropped, but, interestingly, so did Berkshire Hathaway. Now, you might recall that Berkshire Hathaway took an investment in Goldman Sachs in the midst of the crisis. So the question arises, what is the nature of this connection? And what does it mean for investors?

Here with me, to dig into that, is Morningstar's Paul Larson. He is an equity strategist and the editor of Morningstar StockInvestor. Paul, thanks for joining me.

Paul Larson: Thanks for having me.

Stipp: So take us back to September 2008, first of all, and remind us, what was the nature of the investment that Berkshire took in Goldman? So that we can understand this relationship.

Larson: At the height of the crisis, Berkshire Hathaway invested $5 billion into Goldman Sachs, into Goldman preferred stock. And Berkshire received a 10% coupon on that particular investment, a very attractive investment for Berkshire Hathaway. And then, also as part of that deal, almost as a throw-in, Berkshire received the right to buy 43.5 million shares of Goldman at $115 a share. And those were just barely in the water right when the deal was struck. But with the market rebounding, and Goldman rebounding, that particular investment has grown immensely for Berkshire.

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Stipp: So there obviously then is a direct connection here, and there is a stake, Berkshire does have a stake, in Goldman. Goldman fell about 13% on that Friday that the indictment was announced, and Berkshire was down 2%. Now, do you think that that drop, that the sales of Berkshire [stock], did it make sense for the extent of the investment that Berkshire has in Goldman?

Larson: To summarize, I think the market overreacted here and continues to overreact. It was painful for Berkshire Hathaway, on the day that the SEC indictment was revealed, because Berkshire's warrants, which are basically stock options, those fell in value by roughly $1 billion. But the market value of Berkshire stock fell by three times that amount, so there's a little bit of a disconnect regarding how much of a sell-off should have occurred.

Stipp: So it was almost like the market saw Goldman in trouble, they remembered the investment that Berkshire made, and all of the attention was on this one investment. Of course, Berkshire has a much broader portfolio, than just the investment in Goldman.

Larson: I think you hit the nail on the head. Berkshire is a very broad-based company. And this is a company that has a balance sheet that has, after the Burlington Northern investment, roughly $150 billion worth of equity on it. So when you lose one billion of 150, it's really not going to move the needle.

Stipp: So, certainly it does seem like there was a bit of a market overreaction in that case, but there are some broader things that are happening, with regulation and financial reform that could potentially could affect both Goldman and Berkshire. Tell us a little bit about what you're seeing there, and how there might be some indirect connections between these two companies.

Larson: Right. There are some indirect connections, in that both companies are going to be affected by the financial regulatory reform that is currently being debated in Washington, D.C. What the final form of what that regulatory structure is going to be is really anyone's guess at this point in time. But whatever is bad for Goldman Sachs, is probably also going to be a mild negative for Berkshire Hathaway, particularly when it comes to derivatives. If there are any sort of increased requirements regarding the collateral that stands behind these derivatives, that could significantly crimp Goldman's style and mildly crimp Berkshire's style.

Stipp: So potentially, though, the market might overreact again if there is some sort of regulation here, and might present, possibly, an opportunity to pick up some Berkshire shares, if they get depressed over this one issue that might affect it mildly.

Larson: Yes, that could an interesting opportunity to buy Berkshire. Right now, we don't think that Berkshire is in the "buy" territory, but...

Stipp: Something to keep on the radar.

Larson: It's certainly something to keep on the radar.

Stipp: Sure, last question for you, and we've gotten some questions from readers about this. Buffett has famously said that derivatives were weapons of mass destruction, and yet now he's back in the news with this derivatives issue. And it almost seems like it's coming back to bite him a little bit. He actually holds these things that he was talking against, a while back. What's your take on Berkshire's derivatives positions, and how do you sort of think about them, and think about what he said, and kind of justify those?

Larson: Well, one key difference here is that in most derivatives you have some counterparty risk. And the way that Berkshire's particular derivatives were structured, Berkshire got the cash up front. And so there's really no counterparty risk. All that risk is with Berkshire's counterparty.

I would also say that this is not a meaningful derivatives exposure, that is going to tip over the entire apple cart, if they were to go awry. And Berkshire has the financial strength to pay these off, should it come to that. It's worth noting that, right now, Berkshire is in the black on these particular derivatives on the equity indexes that they made the bet on. And I would expect that they would continue to profit from their derivatives activity.

Stipp: Paul, thanks for the insights and for the context.

Larson: Thanks for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.