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FFH or ORH: which do you like more right now?


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FFH sold off quite dramatically and that got my attention (20% position). In the past week ORH has followed suit. I likely will buy more on weakness and I am trying to understand why I would want to buy ORH.

 

Mungerville, I believe you hold ORH. Can you help me understand why you favour it over FFH? My guess is ORH is much simpler to understand and value and has solid underwriting and better predictability...

 

What do others think?

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I too believe ORH offers better predictability.  Underwriting has been consistently better than FFH since 1998 (when I started following their operations) at 105% vs. 113% (including all operating costs as expenses).  ORH has the edge in ROA and ROE over that same timeframe (3.4% vs. 1.5% and 15.9% vs. 10.4%).  However, FFH has the advantage in leverage (assets to equity of 4.5X vs. 3.5X). So, any marked improvement in FFH underwriting and the tables turn. 

 

Using the average ROA for ORH over the last 10 years, I get a 2009 BV (including investments at equity revalued to market less taxes) of around 51.50, suggesting ORH is trading at .71X BV today.  Using a ROA of 2% for FFH (0.5% higher than their 10 yr. average), I get a 2009 BV of 307.40, suggesting 0.75X BV.  ORH looks slightly better value than does FFH on these assumptions/metrics.

 

I have a question with regard to LEAPS.  Where do I find LEAPS on ORH?  I have a position in ORH pref-A and would like to attach some long-dated calls to them for a quasi-convertible.  With a dividend yield of less than 1% on the common, I give up little on the calls.  Add to that the real prospect of the pref-A being redeemed as early as October 2010, given how expensive it is to the company on a tax-equivalent basis, and I think this could be a Big Idea.

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How to chose between ORH-A and ORH-B series

 

Other than the interest rate (8.125% for ORH-A and 3moLibor +3.5% for ORH-B), they look the same.

They are essentially could be convertible in 10/20/2010 at $25/share.

 

so if i have to chose between them, what should i pick ?

 

(if there is going to be inflation, they may convert the B's if the interest rate shoots up more than 8.125)

 

Any other factors ?

 

 

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How to chose between ORH-A and ORH-B series

 

Other than the interest rate (8.125% for ORH-A and 3moLibor +3.5% for ORH-B), they look the same.

They are essentially could be convertible in 10/20/2010 at $25/share.

 

so if i have to chose between them, what should i pick ?

 

(if there is going to be inflation, they may convert the B's if the interest rate shoots up more than 8.125)

 

 

WRT the ORH preferreds, I would expect that both the A and B series will be bought back in about 2 years, implying that inflation may not even be a consideration. 

 

The A series is relatively expensive capital, as 8.125% after tax would be 11 or 12 percent before tax.  Prem and his team are investing geniuses, but it strikes me as a no-brainer to buy back your own preferreds and debt at 11 or 12 percent before dishing out money to Abitibi, Megablox, or even H&R at similar rates of return.

 

The B series is not quite so clear as it is currently cheaper for ORH than the A series, but when LIBOR stabilizes at around 4% or so, there may be a compelling case to re-purchase it too.  Even 7% after tax is relatively expensive on a before tax basis.

 

SJ

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This is a basic question on preferred shares.

 

Can the companies start buying their own preferred shares from open market, without any announcement ?

 

Do they need any approval from common stock holders or regulatory bodies ?

 

With so much discount from the par value and such high yields, what could be stopping them from buying and retiring the debt ?

 

 

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I am also curious to hear the answer to your question. I did find this in the ORH annual report:

 

"During the year ended December 31, 2008, Odyssey America purchased 128,000 shares of our Series B preferred stock, with a liquidation preference of $3.1 million, for $1.7 million. As a result of the purchase of the Series B preferred shares, we recorded a gain of $1.4 million during the year ended December 31, 2008, which was recorded in retained earnings and included in net income available to common shareholders."

 

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I'm no expert on pfds but I have been reading lots of prospectuses recently.

 

As far as I can tell, banks do need approval to buy back their pfds (a capital adequacy thing, I believe). I have not found anything in ORH's prospectus that precludes them from buying back the pfds and the recent purchases would seem to confirm this.

 

Given where bank pfds and bonds are trading, it has struck me that the banks could materially repair their balance sheets if they had the ability to buy back and cancel their debt and pfds for pennies (ok, maybe quarters) on the dollar. These buybacks would also have the impact of stabilising the debt markets. I wonder why the Treasury has not considered this route of aiding the banks.

 

Everyone seems to be focused on the asset side, not the liability side of the balance sheet. In fact, this is how I think the deleveraging of the US economy could be achieved not just for the banks but for all the other corporations - bondholders will have to take haircuts. Especially on the private equity side, irrationally exuberant lenders will eventually be forced to take losses or accept debt-to-equity swaps.

 

Sorry if I digress! :D

 

 

 

 

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WRT the preferred buybacks, I'm not too sure that open market purchases will be that relevant in Q1 or Q2 2009 as the ORH common shares have been trading at $35-38.  At those prices, I expect that we will see ORH actively gobbing up as many common shares as they can -- just as they've done over the past 18 months or so.  This really reflects the "FFH creeping takeover" hypothesis that we've kicked around.  However, at some point common sense will return to the market and the common shares will at least rise to somewhere near book value (this finally occurred in about Q4 last year) and maybe there'll be some leftover cash for the preferreds.

 

In any case by the time 2010 rolls around and the preferreds can be called at $25, it will be a compelling proposition.  At that time there will be a number of options available to ORH:

 

1) Do nothing, continue to pay 8.125% after tax for Series A, or about 11-12 percent before tax.

2) Use ORH's excess cash/regulatory capital to call the series, thus improving annual cash available to common holders.

3) Borrow money on the open market at 8, 9, or 10% before tax to repay the preferreds.

4) Borrow money from FFH at 8, 9, or 10% before tax to repurchase the preferreds.

 

Any of #2-4 would be beneficial to ORH common shareholders.  Obviously, #4 would be beneficial to both ORH and FFH shareholders!

 

SJ

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Guest ericopoly

4) Borrow money from FFH at 8, 9, or 10% before tax to repurchase the preferreds.

 

 

I don't see how that would benefit FFH -- that's sort of like the left hand paying the right hand.  I'm working from the assumption that ORH has the cash to pay off the preferred without borrowing from FFH holdco, so to use up holdco liquidity to put more liquidity in ORH's hands... I just don't see what that accomplishes.  Those interest rates aren't very good compared to what FFH holdco is already paying out on money it has borrowed.

 

 

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4) Borrow money from FFH at 8, 9, or 10% before tax to repurchase the preferreds.

 

 

I don't see how that would benefit FFH -- that's sort of like the left hand paying the right hand.  I'm working from the assumption that ORH has the cash to pay off the preferred without borrowing from FFH holdco, so to use up holdco liquidity to put more liquidity in ORH's hands... I just don't see what that accomplishes.  Those interest rates aren't very good compared to what FFH holdco is already paying out on money it has borrowed.

 

 

 

Well, if it were your money, would you invest it in Megablox at 8%, Abitibi Bowater at 8%, H&R at 11.5% or ORH at somewhere between 8-10%?  I know where I'd put my money!  For FFH, assuming that there is any need for capital in the sub in 2010 (and seeing the current ORH common price, I'm guessing that ORH is blasting piles of cash out the door on repurchases), a loan to ORH might be a reasonable way to use excess capital at the holding co level. 

 

But overall, I would agree that FFH should be considering holdco debt repurchases too, to the extent this is possible.  That's the nice thing about the ORH preferreds is that they have the option to call them in 2010.

 

So many good choices available!

 

SJ

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Well, if it were your money, would you invest it in Megablox at 8%, Abitibi Bowater at 8%, H&R at 11.5% or ORH at somewhere between 8-10%?

 

 

Good question, let's put it in terms of what I would do if it were my money:

 

Let me see:

1)  I am already borrowing hundreds of millions with my left hand at 8% rates.

2)  Is it a screaming deal to loan it to my right hand at at 0-2% net interest margin, even though I own 70.5% of the person paying me the interest?

 

That's what I'm getting at.

 

And what's with the false choices?  It's not Megablox or ORH, it's ORH vs the universe.  Why didn't you suggest WFC preferred at 20+%?

 

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Guest ericopoly

I hope you understand that I agree ORH should retire and buyback stock and preferreds. 

 

I'm an FFH shareholder though and I don't want to see my ownership finance something that will benefit ORH minority shareholders 100% but FFH shareholders only 70.5%.

 

Here's an idea:  Suppose FFH holdco just buys the ORH preferred instead?  This way, FFH shareholders get 100% of the benefit instead of just getting 70.5% of the benefit.

 

 

 

 

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WRT the preferred buybacks, I'm not too sure that open market purchases will be that relevant in Q1 or Q2 2009 as the ORH common shares have been trading at $35-38.  At those prices, I expect that we will see ORH actively gobbing up as many common shares as they can -- just as they've done over the past 18 months or so.

 

At current prices, it would cost only about $60m to buy back the preferreds. If the intention were to redeem the preferreds in 2010 anyway, it would make more sense for ORH to do as much buying back now as it can and get the "free" $40m. At the very least, it makes sense to spend $34m to buy back the A pfd. I'm not so sure they will redeem the Bs in 2010 - unless LIBOR is significantly higher then.

 

1)  I am already borrowing hundreds of millions with my left hand at 8% rates.

2)  Is it a screaming deal to loan it to my right hand at at 0-2% net interest margin, even though I own 70.5% of the person paying me the interest?

 

FFH's current investment decisions should not be based on their cost of borrowing which is a "sunk cost." It should be based on what they are earning on their lowest yielding investible asset currently which must be either cash or T-bills. There is nothing illogical with FFH giving a loan to ORH at 8-10% if that is considered a fair arm's length rate. Having said this, I agree with your later post that FFH should probably just buy the pfds directly.

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Well, if it were your money, would you invest it in Megablox at 8%, Abitibi Bowater at 8%, H&R at 11.5% or ORH at somewhere between 8-10%?

 

 

Good question, let's put it in terms of what I would do if it were my money:

 

Let me see:

1)  I am already borrowing hundreds of millions with my left hand at 8% rates.

2)  Is it a screaming deal to loan it to my right hand at at 0-2% net interest margin, even though I own 70.5% of the person paying me the interest?

 

That's what I'm getting at.

 

And what's with the false choices?  It's not Megablox or ORH, it's ORH vs the universe.  Why didn't you suggest WFC preferred at 20+%?

 

 

It's not a question of borrowing new money at 8% and lending it out at 10% for a 2% margin.  All the excess capital at the FFH holding level reflects retained earnings, not some 8% debt that they issued in 2005.  Obviously if FFH were in a position to retire some of its bonds, that would be an excellent choice, and it would support their broader de-leveraging initiative.  However, beyond making some marginal debt repurchases through the market, there is really a significant constraint in that AFAIK, there is no call feature on their debt.   

 

If you cannot retire your own debt, what are the other alternatives?  Common re-purchases can be a good idea at the right price (and currently we have the right price!), but who knows whether the share price will be reasonable in October 2010?  Investing excess capital can be a good idea if you can get a good return on your investment (and WFC-L currently looks to be a good return!).  Or, if you have some preferred shares somewhere in your corporate structure, you could consider looking for a mechanism to retire them and save the annual dividend -- fortunately, the preferreds actually have a call feature which enables a bulk re-purchase.

 

Right now, the $100m in ORH-A costs ORH about $8.125m per year in dividends.  FFH's effective share of this cost is about $5.7m, since they are majority owner...and don't forget, this is after-tax money, so on a pre-tax basis it's more like $11m for ORH of which FFH's share would be perhaps $7.8m.  FFH could lend ORH $100m for free to fund a preferred repurchase, and FFH would effectively get a pre-tax return of about 7.8%....risk-free.....the return would actually be marginally better if they actually charged ORH a bit of interest on the $100m!

 

You are right that I offered a series of false choices about some of the potential alternate investments that could be made instead of using holdco money to fund preferred repurchases.  The point of that was simply to show some of the places where large blocks of money have been invested over the past year, and describe some of the terms that FFH was able to negotiate.  Compared to some of the risky investments made over the past year (ie, JNJ, H&R, Abitibi, USG), debt or preferred repurchases should be a no-brainer.  Going forward, Prem's phone may be ringing a fair bit over the coming year, and there may be better opportunities in which to sink $100m (but it won't be WFC-L because, in total, there is only about $100m of WFC-L).  But compared to last year's opportunities, the risk-free preferred repurchase looks pretty good...

 

Anyway, thinking back to five years ago, this debate about what to do with surplus capital is a rather discussion.  Back then, we were worried about holding company liquidity and whether FFH could find cash anywhere!

 

SJ

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Guest ericopoly

Compared to some of the risky investments made over the past year (ie, JNJ, H&R, Abitibi, USG), debt or preferred repurchases should be a no-brainer.

 

 

I mentioned this a couple of years ago, but just to repeat myself the long-term debt that Fairfax owes is actually an inflation hedge, and it's also a hedge against a major cat strike that would leave an operating company in need of liquidity at a time when liquidity is potentially scarce.

 

I know it sounds counterintuitive, but FFH's debt load actually reduces their risk profile, not increases it.  It carries a cost of course, as any hedge does.  Yet even if they had no debt and instead had a big cash cushion, that too would carry a cost (opportunity).  I think I would rather they never pay this debt off as long as they can roll it -- just let their growth dwarf their debt over time.

 

I think you raise an important point about the ORH preferred being after-tax payments -- that's an expensive thing, but I like what they did with NB (their returns on NB ought to dwarf what they pay out on ORH preferreds).  I would like to see a similar deal for ORH someday -- the returns on that would be greater than the preferred costs, but then again the preferreds are the more certain risk-free return.

 

The other thing about the false choices -- you didn't mention the common stock conversion option.  Take away that feature and the interest rates would have been much higher.  The USG rate for example would have been 20% without the conversion feature.

 

 

 

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Looks like Odyssey Re is forming OdysseyRe Capital Trust I. From my limited understanding, it looks like they are setting up a trust to go out and purchase their debt. I don't know why you would set up something like this unless it allows for better tax treatment. Any thoughts or comments would be appreciated! Here is an excerpt from the beginning and the link is below to the SEC listing.

 

http://www.sec.gov/Archives/edgar/data/1137048/000090956709000251/0000909567-09-000251-index.htm

 

Description of the trust:

We formed OdysseyRe Capital Trust I, a Delaware statutory trust, to raise capital for us by:

 

• issuing trust preferred securities under this prospectus; and

 

• investing the proceeds from the sale of the trust preferred securities in our junior subordinated notes.

 

The trust will use the payments it receives on the junior subordinated notes to make cash payments to the holders of the trust preferred securities.

 

We will own all of the common securities of the trust. Such common securities will represent an aggregate liquidation amount equal to at least 3% of the trust’s total capitalization. Such common securities will have terms substantially identical to, and generally will rank equal in priority of payment with, the trust preferred securities. If we default on the corresponding junior subordinated notes, then distributions on such common securities will be subordinate to the trust preferred securities in priority of payment.

 

As holders of the common securities, we (except in certain circumstances) will have the power to:

 

• appoint the trustees of the trust;

 

• replace or remove any of the trustees; and

 

• increase or decrease the number of trustees.

 

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At this juncture it wouldn't be a very good use of capital to retire debt.  It would probably weaken their credit ratings as the agencies look at financial flexibility.  The ability to raise debt and pay debt is part of the rating.  I expect you will see the company move the debt out in cycles every couple of years to keep it distant, and perhaps at lower rates.  They are in a good position now where the debt will benefit rather than hurt the company.

 

As mentioned, the debt is also an inflation hedge. 

 

RE: ORH filing.  This is a little confusing.  It looks to me as if they are trying to buy in some of the debt and preferreds at the low price to maturities.  Any other thoughts?

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I believe the intention is to use the trust vehicle to raise new debt for ORH in the form of junior subordinated debt.

 

As discussed elsewhere, the proceeds from this debt raising could be used to buyback the existing pfds. Sub debt costing 8% would be much cheaper than the ORH.PR.A 8% (paid from after tax income). Question is whether sub debt can be issued at 8% in the current environment. They could just be preparing to take advantage when market conditions become more favourable.

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