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Great post to get us bulls to consider the flip side of the argument. You've connected some dots that I failed to connect myself and make a compelling case.

 

I have one nitpicky piece of feedback:

When discussing U.S. debt/GDP you show a graph of the leverage of government debt to GDP. This seems reasonable but I believe it's incorrect. I don't have proof on hand but I'm pretty sure Prem was referencing total debt (private, corporate, and public). The picture is a lot different when you consider all three.

 

Also, I haven't run the numbers myself, but are the calculations if actual book value growth inclusive of the CDX bets that Watsa typically excludes? If so, I believe this should be reevaluated.

Thanks for the thoughts

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Thank you, this is a good article and it reflects / restates many of the questions I have had about Fairfax's "hedges".

 

The idea that Fairfax is being forced to sell its core long term equity holdings in order to satisfy cash calls for its hedges does ring true, and would be very worrisome if accurate.  Even more worrisome would be if Watsa is not highlighting this since it has a significant effect on their investment returns and performance.

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Thank you, this is a good article and it reflects / restates many of the questions I have had about Fairfax's "hedges".

 

The idea that Fairfax is being forced to sell its core long term equity holdings in order to satisfy cash calls for its hedges does ring true, and would be very worrisome if accurate.  Even more worrisome would be if Watsa is not highlighting this since it has a significant effect on their investment returns and performance.

 

+1. Blog is good and "says it as it is", reasons why I sold completely out after attending the AGM in 2013. Issuing shares, selling long term holdings etc. purportedly to raise cash tell an unnerving story. Good to note that they had a good year as an insurance biz,  How will they fare if there are two or three years of major, multiple catastrophes? I may look at them after a minimum of 3 years of demonstrating their insurance business prowess during good and bad years. In the meantime, my money will ride with BRK which, like the blogger, allows me to sleep well. Who knows, I may never have to look at FFH again.

 

Good luck to the FFH bulls. FFH/Prem made me a ton of money over the past decade.

 

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Nice post.  I will echo, however, what a previous poster said, they are focused on total debt, not government debt, and it looks quite a bit worse.  That does not mean, however, that I think macro calls are a good idea.

 

With regard to the hedging, I have had a large problem understanding them.  This year, I think I might understand them a bit better.  Here are some notes regarding them that I remember:

 

1) There were lots of questions about this at the railcar and at the dinner.  One thing that came up is when they would exit the hedges.  The answer was: a) if everything goes down as they expect, they'll cash out and invest the cash; b) if everything goes up, they will realize the gains and take off a corresponding amount of hedges, as they did this year (I interject here that I agree with the comments regarding selling of long term positions, particularly WFC).

 

2) Pabrai also commented on this and I asked him a couple of questions about it the next day.  Basically, his view is that there is an incredible amount of leverage in FFH, and that they are preserving the equity portion.  Running some math, if their investment portfolio had a mark to market loss of ~25%, the equity would go to zero (I think, please correct me if I'm wrong here).  If I were in that situation, I'd be pretty frightened of such a loss.  At the same time, however, they have had periods of unhedged investing, so if that were truly the whole story, why did they unhedge ever?  I don't really know.

 

3) Following on, I think Gio a couple of questions that were quite good, and at one point during the answer, they said as their equity portion gets larger, they will have more flexibility (e.g., for buying companies or doing other interesting things).  From this, it is my impression that they will stop hedging past a certain amount of capital (e.g., 6-7 billion, I think), which relates back to the leverage issues in 2). 

 

After piecing together those, I think I understand the hedging a little more, or am willing to give some benefit of the doubt.  However, it seems as though they did not need to be 100% hedged and there is at least some element of macro calling going on, which I am uncomfortable with. 

 

I think the communication on the hedges has been very confusing.  I want to know how much is based on macro calls or the capital levels/leverage discussed above.  They never spell this out, and everything is in vague phrasing like "protect our capital" and "grand disconnect".  I want the actual rationale, e.g., if it is the capital levels, they are concerned that the leverage could kill them without the hedges; if it is a macro call, just say "this is a macro call".  I don't think we should have this many people be confused about the whole strategy and reasoning.  I don't feel like we're getting straight answers, or at least I feel like I shouldn't be constantly confused about what exactly the purpose of the hedges are.

 

 

Finally, I generally have a historical hedging question:  does anyone know how often they have been hedged over their entire career, and to what extent?  Moreover, the equity returns with hedging is terrible over 5 years and is barely above market over 10.  What is long term if not 5 and 10 years?  Perhaps everything will suddenly start working, but I find it very confusing.

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2) Pabrai also commented on this and I asked him a couple of questions about it the next day.  Basically, his view is that there is an incredible amount of leverage in FFH, and that they are preserving the equity portion.  Running some math, if their investment portfolio had a mark to market loss of ~25%, the equity would go to zero (I think, please correct me if I'm wrong here).  If I were in that situation, I'd be pretty frightened of such a loss. 

 

 

Thanks for the meeting notes.

 

Common share holder equity is about $7 billion and Stock/Preferred stock investments are about $5 billion. So I cannot see how even a 50% loss on equity/preferred stock would wipe out Fairfax.

 

It does not make sense to consider a loss of 25% on the entire investment portfolio consisting of stocks, bonds, cash. The hedges only protect the equity portion.

 

Vinod

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2) Pabrai also commented on this and I asked him a couple of questions about it the next day.  Basically, his view is that there is an incredible amount of leverage in FFH, and that they are preserving the equity portion.  Running some math, if their investment portfolio had a mark to market loss of ~25%, the equity would go to zero (I think, please correct me if I'm wrong here).  If I were in that situation, I'd be pretty frightened of such a loss. 

 

 

Thanks for the meeting notes.

 

Common share holder equity is about $7 billion and Stock/Preferred stock investments are about $5 billion. So I cannot see how even a 50% loss on equity/preferred stock would wipe out Fairfax.

 

It does not make sense to consider a loss of 25% on the entire investment portfolio consisting of stocks, bonds, cash. The hedges only protect the equity portion.

 

Vinod

 

Yeah, I was referring to the whole portfolio.  It does seem highly unlikely (particularly given their cash portion), but there have also been large mark-to-market bond losses.  Although it seems like it would be unlikely to have a quarter/year where both bonds and stocks went down at the same time...

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Yeah, I was referring to the whole portfolio.  It does seem highly unlikely (particularly given their cash portion), but there have also been large mark-to-market bond losses.  Although it seems like it would be unlikely to have a quarter/year where both bonds and stocks went down at the same time...

 

Dont they need to short the bond market also to hedge this risk?

 

Vinod

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I enjoyed it. Thanks for posting.

 

However, just something to think about from a return perspective. Let's say if the post would have been written in 2009. Watsa would be looking like a genius over Buffett, I'd think. The fact the market has been manipulated by the Fed, doesn't mean he's wrong. Yeah, so far it looks like he's wrong, but I think he'll be proven to be right. These guys very often look like idiots...until they're not. Cases in point - Buffett in 1999 or Burry in 2006 with Greenblatt pulling money out. We shall see.

 

For fun, here's what I'm thinking. Let's say, someone asked you what your returns would after about 6 years if you would have bought the S&P 500 in 2007 at the height at that we'd then enter the worst recession since the Great Depression. One you expect negative returns? I'd think so. But that's not what happened

 

If one would have bought the S&P 500 near the height in 2007 and didn't sell, you would still have returns of roughly 5.5%. That seems too good to be true! It's better than a lot of time periods...let alone one of the worst periods ever.

 

 

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I fear that if FFH is proven right on their current macro call, then they would be more likely to make future macro calls!

 

Successfully forecasting macroeconomic events is inherently hard. As a shareholder I want them to simply stick to their knitting.

 

I almost wish that they are proven wrong so that they can dust off and get back to real work.

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2) Pabrai also commented on this and I asked him a couple of questions about it the next day.  Basically, his view is that there is an incredible amount of leverage in FFH, and that they are preserving the equity portion.  Running some math, if their investment portfolio had a mark to market loss of ~25%, the equity would go to zero (I think, please correct me if I'm wrong here).  If I were in that situation, I'd be pretty frightened of such a loss. 

 

 

Thanks for the meeting notes.

 

Common share holder equity is about $7 billion and Stock/Preferred stock investments are about $5 billion. So I cannot see how even a 50% loss on equity/preferred stock would wipe out Fairfax.

 

It does not make sense to consider a loss of 25% on the entire investment portfolio consisting of stocks, bonds, cash. The hedges only protect the equity portion.

 

Vinod

 

There were two points that clarified this hedging issue for me, one point at the Railcar event, and one during the shareholder dinner.

 

At the Railcar one of the FFH guys mentioned that the Canadian regulators would at most give 50% credit to their equity investments.  This is a major issue, so they have two choices.  They can invest in bonds and cash and get full credit, or hedge the equity to get full credit.  They could potentially also raise equity by selling shares, although I don't consider that much of an option.

 

So in order to satisfy the regulators they need to be protected against a lost.  At some point the market will fall, it's not a matter of if, but of when.  When the market falls they can dump the hedges and make more investments without a hedge.  The math on this works because they're able to double down on investments and with a 50% regulatory penalty they don't lose any ground.

 

At the dinner Paul made a few comments reinforcing this but also went a step further.  It's almost as if there are two things going on here.  The team is investing as they always have, they are generating the types of returns they want.  They're very confident in the investments they have now, that Greek REIT, restaurants etc.  It's a timing issue, they expect the market to fall before these investments are realized.  And to be able to invest at all they need to show to regulators that their capital won't be wiped out.  So they are forced to hedge.  The hedge protects them in a downdraft, but it's almost independent of the underlying investments.

 

Someone quoted Prem as saying that protecting capital is the most important issue, and that AIG took decades to build billions in equity that was wiped out in a year.  Remember that Fairfax is first and foremost an insurance company.  They are not a hedge fund, or a mutual fund.  All of their activities support their insurance, and this is how regulators view them as well. 

 

So why haven't they ever called this out explicitly?  It doesn't seem in good taste to call out regulators.  But I think it's even simpler then that.  I think that Prem and his team take this for granted.  They are an insurance company, they deal with regulators and capital issues all the time.  This is the lens they think in, I think they presume that investors understand this as well.

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Thanks for the clarification - but it seems most of FFH insurance operations are in the U.S and will be governed by U.S insurance regulators?

 

 

2) Pabrai also commented on this and I asked him a couple of questions about it the next day.  Basically, his view is that there is an incredible amount of leverage in FFH, and that they are preserving the equity portion.  Running some math, if their investment portfolio had a mark to market loss of ~25%, the equity would go to zero (I think, please correct me if I'm wrong here).  If I were in that situation, I'd be pretty frightened of such a loss. 

 

 

Thanks for the meeting notes.

 

Common share holder equity is about $7 billion and Stock/Preferred stock investments are about $5 billion. So I cannot see how even a 50% loss on equity/preferred stock would wipe out Fairfax.

 

It does not make sense to consider a loss of 25% on the entire investment portfolio consisting of stocks, bonds, cash. The hedges only protect the equity portion.

 

Vinod

 

There were two points that clarified this hedging issue for me, one point at the Railcar event, and one during the shareholder dinner.

 

At the Railcar one of the FFH guys mentioned that the Canadian regulators would at most give 50% credit to their equity investments.  This is a major issue, so they have two choices.  They can invest in bonds and cash and get full credit, or hedge the equity to get full credit.  They could potentially also raise equity by selling shares, although I don't consider that much of an option.

 

So in order to satisfy the regulators they need to be protected against a lost.  At some point the market will fall, it's not a matter of if, but of when.  When the market falls they can dump the hedges and make more investments without a hedge.  The math on this works because they're able to double down on investments and with a 50% regulatory penalty they don't lose any ground.

 

At the dinner Paul made a few comments reinforcing this but also went a step further.  It's almost as if there are two things going on here.  The team is investing as they always have, they are generating the types of returns they want.  They're very confident in the investments they have now, that Greek REIT, restaurants etc.  It's a timing issue, they expect the market to fall before these investments are realized.  And to be able to invest at all they need to show to regulators that their capital won't be wiped out.  So they are forced to hedge.  The hedge protects them in a downdraft, but it's almost independent of the underlying investments.

 

Someone quoted Prem as saying that protecting capital is the most important issue, and that AIG took decades to build billions in equity that was wiped out in a year.  Remember that Fairfax is first and foremost an insurance company.  They are not a hedge fund, or a mutual fund.  All of their activities support their insurance, and this is how regulators view them as well. 

 

So why haven't they ever called this out explicitly?  It doesn't seem in good taste to call out regulators.  But I think it's even simpler then that.  I think that Prem and his team take this for granted.  They are an insurance company, they deal with regulators and capital issues all the time.  This is the lens they think in, I think they presume that investors understand this as well.

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Thanks for the clarification - but it seems most of FFH insurance operations are in the U.S and will be governed by U.S insurance regulators?

 

 

2) Pabrai also commented on this and I asked him a couple of questions about it the next day.  Basically, his view is that there is an incredible amount of leverage in FFH, and that they are preserving the equity portion.  Running some math, if their investment portfolio had a mark to market loss of ~25%, the equity would go to zero (I think, please correct me if I'm wrong here).  If I were in that situation, I'd be pretty frightened of such a loss. 

 

 

Thanks for the meeting notes.

 

Common share holder equity is about $7 billion and Stock/Preferred stock investments are about $5 billion. So I cannot see how even a 50% loss on equity/preferred stock would wipe out Fairfax.

 

It does not make sense to consider a loss of 25% on the entire investment portfolio consisting of stocks, bonds, cash. The hedges only protect the equity portion.

 

Vinod

 

There were two points that clarified this hedging issue for me, one point at the Railcar event, and one during the shareholder dinner.

 

At the Railcar one of the FFH guys mentioned that the Canadian regulators would at most give 50% credit to their equity investments.  This is a major issue, so they have two choices.  They can invest in bonds and cash and get full credit, or hedge the equity to get full credit.  They could potentially also raise equity by selling shares, although I don't consider that much of an option.

 

So in order to satisfy the regulators they need to be protected against a lost.  At some point the market will fall, it's not a matter of if, but of when.  When the market falls they can dump the hedges and make more investments without a hedge.  The math on this works because they're able to double down on investments and with a 50% regulatory penalty they don't lose any ground.

 

At the dinner Paul made a few comments reinforcing this but also went a step further.  It's almost as if there are two things going on here.  The team is investing as they always have, they are generating the types of returns they want.  They're very confident in the investments they have now, that Greek REIT, restaurants etc.  It's a timing issue, they expect the market to fall before these investments are realized.  And to be able to invest at all they need to show to regulators that their capital won't be wiped out.  So they are forced to hedge.  The hedge protects them in a downdraft, but it's almost independent of the underlying investments.

 

Someone quoted Prem as saying that protecting capital is the most important issue, and that AIG took decades to build billions in equity that was wiped out in a year.  Remember that Fairfax is first and foremost an insurance company.  They are not a hedge fund, or a mutual fund.  All of their activities support their insurance, and this is how regulators view them as well. 

 

So why haven't they ever called this out explicitly?  It doesn't seem in good taste to call out regulators.  But I think it's even simpler then that.  I think that Prem and his team take this for granted.  They are an insurance company, they deal with regulators and capital issues all the time.  This is the lens they think in, I think they presume that investors understand this as well.

 

I don't know, my knowledge of Fairfax went from zero to everything I know by attending the events in Toronto.  In the US if you're a holding company that owns a bank you are regulated even though the subsidiary does the banking.  My guess is that insurance is similar, the actual operating entity is regulated, but the holdco is as well.  This is to prevent a situation where the holdco makes decisions that could financially jeopardize the subsidiaries.

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Another point brought out about the hedges was that they could continue to write insurance if a hard market was coincident with a decline in equity values when others may not be able to write insurance.  I got a better appreciation of the hedges this year.  If they think they can achieve alpha in the market,  then the best course of action is to keep them on for regulatory protection and to have the ability write insurance into a hard market without raising equity.  There highly leveraged position they are in is what is causing this.  If they had the leverage of BRK or MRK, I think the hedges would not be there. 

 

Packer 

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Thanks everybody for the kind words. Just the ramblings of one man to be taken with a grain of salt.

 

I have one nitpicky piece of feedback:

When discussing U.S. debt/GDP you show a graph of the leverage of government debt to GDP. This seems reasonable but I believe it's incorrect. I don't have proof on hand but I'm pretty sure Prem was referencing total debt (private, corporate, and public). The picture is a lot different when you consider all three.

 

Also, I haven't run the numbers myself, but are the calculations if actual book value growth inclusive of the CDX bets that Watsa typically excludes? If so, I believe this should be reevaluated.

Thanks for the thoughts

 

Correct, I believe that graph is government debt to GDP. I thought that's what they were referencing also, so you're right, it would be higher.

However, even the graph I showed was just an example of how someone might bring another fact to the table to contradict what Fairfax might be basing themselves on. Even if we're dealing with total debt to GDP a person could ask how about the fact that a huge portion of that is held by the Federal reserve, even the private sector debt since they've been buying billions of MBS with quantitative and qualitative easing. And the Federal Reserve happens to be the one entity that can afford to have a holding period that comes as close to eternity as humanly possible. What's the answer? I certainly don't know, that's my whole point and why I think making macro pronouncements is a fool's errand.

 

As for the BV, I used the numbers Prem provides in his letter on page 7. The table he provides every year that shows a CAGR of 21% over the life of the company.

 

 

1) There were lots of questions about this at the railcar and at the dinner.  One thing that came up is when they would exit the hedges.  The answer was: a) if everything goes down as they expect, they'll cash out and invest the cash; b) if everything goes up, they will realize the gains and take off a corresponding amount of hedges, as they did this year (I interject here that I agree with the comments regarding selling of long term positions, particularly WFC).

 

Here's the thing though, in your scenario if everything goes up and they are hedged 100%, it's not like they're really realizing gains since there's a realized loss that then comes with it, this is something that they're also doing in that when they talk about this it seems like they are describing the selling of their holdings as realizing the gains or cashing in on the gains but on the hedge side it is described as adjusting them because they sold equities, I would want more emphasis put on the fact these are losses that are being realized, i.e some of that cash that they had to pay out over the course of the contract will not come back because the contract just got sold to someone else.

 

Seeing the discussion here is exactly why my post was geared towards pointing out my own reading of details that make me uncomfortable and that I don't think neither Fairfax nor analysts are talking about.

 

To repeat myself a bit, so they have a portfolio of equities and it is hedged 100%, and as the equities go up in value, the hedges go down. Fine. But that's not the whole story, which is a big part of my point. They constantly have to pay cash because of those swap contracts (even if in their mind, it will be recouped eventually if they keep the contract and the equities fall).

If I now see them selling some of their equities, what am I to think? Given that their stated goal is that these are long term positions like WFC and JNJ that they don't want to sell hence the hedges to protect those very same positions.

Well, does it have to do with the cash due to counterparties? It's not like the cash is sitting on their balance sheet, holding company cash is still at $1B.

Like I said in my writeup, at the end of the day I have to come to my own conclusions as an investor and I don't think that Wells Fargo is so overvalued that it deserves to be dumped so if anyone else can offer me a rationale answering my questions then I'm more than willing to look into that.

So I'm left with what I can observe myself, since they're not telling me, and it's that the positions were sold at a time when they had to pay out $2B because of those contracts AND on top of that they issued 1 million shares to raise $400 million in cash at the same time. Why? (like I said in my post we know that probably some of it went into Blackberry) 

 

 

I think the communication on the hedges has been very confusing.  I want to know how much is based on macro calls or the capital levels/leverage discussed above.  They never spell this out, and everything is in vague phrasing like "protect our capital" and "grand disconnect".  I want the actual rationale, e.g., if it is the capital levels, they are concerned that the leverage could kill them without the hedges; if it is a macro call, just say "this is a macro call".  I don't think we should have this many people be confused about the whole strategy and reasoning.  I don't feel like we're getting straight answers, or at least I feel like I shouldn't be constantly confused about what exactly the purpose of the hedges are.

 

Now THIS I agree with wholeheartedly. How hard would it be to just simply explain all of that. I really don't understand the need to be left feeling like the whole truth is not being told. Especially in a company like Fairfax, it's not like something can be forced onto them, Prem controls the majority of voting shares.

 

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<quote>They constantly have to pay cash because of those swap contracts (even if in their mind, it will be recouped eventually if they keep the contract and the equities fall.</quote>

 

On the Russell index swaps I believe FFH switched some of their long equity positions into long swaps so that they would help generate cash settlements to offset those arising from the index swaps.

 

On the deflation swaps which are mark to market through IFRS accounting because they act as purchased option contracts (don't count toward hedge accounting).  The counter party may have to escrow funds, according to Fairfax's wishes, but Fairfax's loss is limited to the premium paid plus or minus the closing value of the contract.  There were some questions regarding the counter parties to these contracts at the ASM.

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