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http://ftalphaville.ft.com/2014/05/12/1846972/guest-post-when-float-is-bad-in-portugal-but-good-in-omaha/

Guest post: When float is bad in Portugal but good in Omaha

Professor Pablo Triana of the ESADE Business School is a derivatives expert whose work we have featured
extensively in this series on the very large put options written by Warren Buffetts Berkshire Hathaway. In this post he
contrasts the fate of bets made by a Portuguese rail operator with those of the Sage of Omaha, where the main
difference is the judgement of hindsight.
What separates the greatest ever trade and the worst is, obviously, the outcome. But should the traders be viewed
any differently for responding to the same motivation: money now for the risk of having to pay more back in the future?
A case in point is the derivatives scandal unfolding in Portugal, where several public sector entities chose to enter
interest rate swaps with leading investment banks that now appear ill-fated. Particular attention has focused on a
rather peculiar swap agreed in 2007 between Banco Santander and Metro doPorto (the citys rail operator).
Though the original notional size of the transaction, at barely 90m, was smallish, the mark-to-market losses for
Metro do Porto have grown to surpass 450m. Metro do Porto has refused to continue to make payments on the
swap, prompting Santander to take court action.
Based on what has been reported, the source of the problems for the state entity lies in the allegedly exotic nature of
the swap. Santander makes an annual net payment of 3 per cent of that notional for fourteen years and in return
Metro do Porto agreed to face the risk of making large payments, after a two-year grace period, to Santander if
several Euribor put and call options happened to be in-the-money.
In essence, Metro do Porto sold some options to Santander and those premiums were monetized in the form of a 3
per cent annual payment. As long as the options are not in-the-money for Santander i.e. Euribor is above 2 per
cent but below 6 per cent the swap would work miracles for Metro do Porto. Like free money, in effect.
The outcome has prompted familiar concerns about the scandalous and prohibitively costly nature of derivatives,
which produced a surely unthinkable 450m loss from a 90m trade. Who but devilishly deviant bankers could
peddle such concoctions? Familiar bromides have fronted the headlines once more. And, of course, we have also
been treated to the tired refrain that the client was insufficiently sophisticated to understand the transaction, rendering
it invalid.
Yet it is auspicious that reports of this scandal have gained traction coincident with Berkshire Hathaways annual
shareholders meeting. For Metro do Portos trade shares a lot in common with what Warren Buffett has so often
done. In fact, the very secret sauce behind Buffetts success lies in strategies that are at heart not too far from the
swap that Santander engineered for its Portuguese client. The only main difference (a big one) may be the fact that
while the Metro do Porto trade has been lambasted and eternally criticized, Buffetts methods have received little but
praise.
What is Buffetts secret sauce? The so-called float generated through the sale of insurance policies and, in more
recent times, derivatives. Berkshire collects upfront premiums from those sales, exposing itself to future potential
losses from payments if the policies, or the derivatives, go against it. When the loss payments turn out to be lower
than the collected premiums, Berkshire obtains positive float, in essence funding at a negative interest rate.
Buffett has been particularly good at this game, being able to obtain funds for Berkshire Hathaway at a much cheaper
cost than the US Government for many years. In any case, Buffett gets to invest the float until any loss payment
materializes, which could be well into the future (some of those derivatives had twenty year maturities), if at all.

The 3 per cent annual payment that Metro do Porto gets through the fateful swap is of course akin to Buffetts float:
someone is willing to had you cash in return for you agreeing to take on some risks linked to a particular financial
market. In the case of Buffett, he sold puts on equity indices and credit default protection, including some exotic
variants. In the case of Metro doPorto, they sold puts and calls on Euribor.
Buffett collected about $9bn upfront, facing the risk that equities would collapse and that corporate defaults would
rise. Metro de Porto collected 3 per cent of the notional amount (initially 90m), each year, facing the risk that interest
rates would either dive down or shoot up.
When credit markets turned, Buffett had to make payments of around $3bn. As Euribor has tumbled post-crisis, Metro
do Porto is facing annualised payments of 40 per cent on the swap, due to an unusual snowballing effect in the way
the payments are structured.
The Portuguese believe that the whole situation is not fair, and thus want a get-out-of-jail card. Of course, at the
beginning they loved the idea of the float and complaints were absent. To not honor the contract would be akin to
Berkshire Hathaway walking away from the equity puts when they expire in 2019-2028 just because its not fair that
stock markets happen to tumble.
With stock markets around the world at or near historic highs, Mr Buffets derivatives now look like one of his greatest
ever trades. But it would have been possible to think that Metro do Porto was onto something similar before Europes
debt crisis hit and interest rates plummeted.
Average Euribor for 2007 was 4.3 per cent, and in 2008 it was 4.6 per cent. Even if you assumed some kind of shock
crisis would take Euribor below 2 per cent, say in 2009, but assume a quick recovery back to normal, say after a
year, the trade looked like genius: Porto gets 0.5 per cent deducted from the spread it pays at every quarterly swap
reset when Euribor is between 2 per cent and and 6 per cent. Porto would take those guys at Santander for 3 per cent
a year for about 12 of the 14 years.
So the float game can be an enticing and attractive one. After all, it is firmly behind the story of the worlds most
successful investor. But with upfront float comes potential future responsibilities. There are no free lunches in the
markets, and neither Santander nor anybody else is going to hand you 3 per cent annually without asking for
something contingent in return.
Mr Buffett too may look less saintly if Berkshire has to pay $20bn in cash between 2019 and 2028 as those put
options come due. Float-seekers should accept that hell can be a possible destination for those looking for instant
heaven on the wings of derivatives.