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Questions about FFH equity hedges


Partner24
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So here is my "far-less-than-perfect" understanding of the FFH equity hedges and I would ask some helps from the boardmembers to verify and correct it.

 

In the end of the last quarter:

 

Fairfax had 3,3 billions notional amount of equity hedges against the Russell 2000 index at an average of 646.5 value (short position). Let's say that the index goes up 30% over a quarter (just an example), that notional amount goes up nearly 1 billion and Fairfax has to put 1 billion $ on the table to cover that change in the underlying value. Let's say that the index goes down 30%, that's the counterparty that has to give us the 1 billion $.

 

You can apply the same principle on the 1,5 billions $ of notional amount of the S&P 500 hedge (average of 1062.52), but on a different scale since the notional amount is different. 

 

Is that correct?

 

So, basically, unlike the credit default swaps and the CPI-linked derivative contract, there is no downside limit to Fairfax to this hedge. Correct?

 

Some might reply that since it's an hedge of the FFH equity portfolio, if the hedge is at lost, normally the portfolio will also go up accordingly so the net will be zero or so (I say or so because it was 90.9% of the portfolio was hedged and our equity portfolio has a different composition then the hedges). That being said, since we have a focused value investing portfolio, it does not mean that our stocks will correlate with the indexes (especially the Russell 2000), so the index could go up significantly and our stocks do nearly nothing and that would mean we would have to put some significant money on the table without being able to sell some shares that have appreciated as much in value than the actual loss. Is my understanding correct?

 

Since it's a swap, we have counterparty risk related to it. So if the company on the other side goes kaput, we will run after our money if the indexes go down in value over a given quarter (because money have to bet given on a quarterly basis). Is that right? If so, do we know who are our counterparty(ies)?

 

Lastly, can we exit these short positions in swaps easily? I would guess yes since they have done that already in 2008, but I would just like to be sure.

 

I understand that my questions might sound like it's actually a bad thing to have (or bashing, some might remember what we saw with some hedge funds some years ago), but that's frankly not what I mean. I just want to fully understand the risks associated to these financial instruments. 

 

Thank you very much for your help!

 

Partner

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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Fairfax had 3,3 billions notional amount of equity hedges against the Russell 2000 index at an average of 646.5 value (short position). Let's say that the index goes up 30% over a quarter (just an example), that notional amount goes up nearly 1 billion and Fairfax has to put 1 billion $ on the table to cover that change in the underlying value. Let's say that the index goes down 30%, that's the counterparty that has to give us the 1 billion $.

 

If the Russell 2k index rallies 30% on a total return basis from 646 to 840, Fairfax is short $3.3B notional at 646 still, and is now underwater on their position by ~$1B ((3.3B / 646) * 840).  As the position moves against Faifax, they are forced to post collateral and mark their position against them.  To my knowledge, their is no factual difference from owning $4.3B (short) swaps at 840 than there is owning $3.3B (short) swaps at 646 as they are equivalent.

 

And yes, if the Russell 2k drops back to 646, we mark our position UP in value, and we get a bunch of collateral back.

 

So, basically, unlike the credit default swaps and the CPI-linked derivative contract, there is no downside limit to Fairfax to this hedge. Correct?

 

100% correct.  Fairfax does some call buying to hedge their shorts, but strictly on the Total Return Swaps it is a completely unlimited downside bet.

 

Some might reply that since it's an hedge of the FFH equity portfolio, if the hedge is at lost, normally the portfolio will also go up accordingly so the net will be zero or so (I say or so because it was 90.9% of the portfolio was hedged and our equity portfolio has a different composition then the hedges). That being said, since we have a focused value investing portfolio, it does not mean that our stocks will correlate with the indexes (especially the Russell 2000), so the index could go up significantly and our stocks do nearly nothing and that would mean we would have to put some significant money on the table without being able to sell some shares that have appreciated as much in value than the actual loss. Is my understanding correct?

 

Your understanding is 100% correct.  This is a mismatched or 'dirty' hedge.  Overtime, it is hedged, in the short term this must be managed and could perform dramatically out of line with Fairfax's portfolio.

 

Since it's a swap, we have counterparty risk related to it. So if the company on the other side goes kaput, we will run after our money if the indexes go down in value over a given quarter (because money have to bet given on a quarterly basis). Is that right? If so, do we know who are our counterparty(ies)?

 

Yes, we do have counterparty risk.  The counterparties are JP Morgan, Citi Canada, and Wells Fargo.  However, the positions are marked regularly and collateral is exchanged which reduces counterparty risk dramatically.  Non-collateralized derivatives are the ones to worry about (most).

 

Lastly, can we exit these short positions in swaps easily? I would guess yes since they have done that already in 2008, but I would just like to be sure

 

This I have trouble answering, but I would imagine, even in a bad scenario, exiting this kind of contract would be the same as exiting a similarly sized investment position (short or long) in the underlying index.  You may have to pay 1-2% extra as a frictional cost, but maybe a derivative expert on the board can step in and set me straight.  In normal markets, these contracts are probably somewhat more liquid than the underlying.

 

I understand that my questions might sound like it's actually a bad thing to have (or bashing, some might remember what we saw with some hedge funds some years ago), but that's frankly not what I mean. I just want to fully understand the risks associated to these financial instruments. 

 

Partner, believe me when I say that anyone who could read your comments above as any sort of bashing, is a complete idiot.  Your questions were valid, and are important IMO.  The most shareholder friendly thing you can do as an owner of a business is to ask good questions and engage with management after doing your own homework.

 

Ben

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Thank you very much Ben for your answers and Myth for your comment!

 

Based on your very good answers, here are some further questions opened to the members of the board:

 

As the position moves against Fairfax, they are forced to post collateral and mark their position against them.

 

Does that mean that Fairfax doesn't have to write a check for the quarterly loss amount to the counterparty and the opposite is true? They mark the losses against some specific assets? If it's the last case, do you know how their rank in the "food chain" with these assets if the counterparty goes bankrupt or liquidate?

 

In normal markets, these contracts are probably somewhat more liquid than the underlying.

 

Let's invert. If the counterparty does want to exit the contract, what happens to us? Do we have to liquidate the collaterized assets and write a check for the whole loss accumulated since the beginning of the contract?

 

Thank you very much!!

 

 

 

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Does that mean that Fairfax doesn't have to write a check for the quarterly loss amount to the counterparty and the opposite is true? They mark the losses against some specific assets? If it's the last case, do you know how their rank in the "food chain" with these assets if the counterparty goes bankrupt or liquidate?

 

Partner, this is how I believe it works. Both parties to the swap will have to pay up the difference every quarter (assuming that is the agreed settlement period). Technically, it is a settlement of the difference and not a posting of collateral (although there is posting of collateral in between the quarterly settlement dates).

 

The quarterly settlements can therefore have significant cashflow consequences for FFH if the indices move materially. This is the reason 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. (Remember the discussion on another thread about why FFH had switched some of the stock positions?)

 

As for your question on what if the counterparty wants to close out the position, the swaps are usually written for a fixed term and it is unlikely that the counterparty can close out before the expiry. In any case, the index swaps are generic ones and should be very liquid barring any major dislocation in financial markets.

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Ok, so based on the appreciated comments above, here it goes:

 

- These equity indexes swaps (short positions) were at 4,8 billions $ value at a 646.5 Russell 2000 index and a 1062.5 S&P 500, wich weight 54% of total equity of Fairfax.

 

- Basically, that means that if the given indexes double and everything else remains the same, we could theorically get back to zero (see next post). I know they have a portfolio of equities, but it's hard to say how much it is correlated to these hedges. They also have some call options, but again it is difficult to say how much it would compensate for the loss in the above catastrophic scenario...so we would probably not be to zero, but our balance sheet would be impacted in a very significant way if the portfolio of equities would not go up enough. Remember that some value investors see their stock portfolios do nearly nothing when everyone is cheerful and make some mint money when the stock markets tank.

 

- The counterparties and Fairfax have to deposit collateral to reflect the changes in value quarterly. That point is still not very clear. Do they have to write a check quarterly to the other party to reflect the change in value of these swaps and post collateral between the quarterly set dates? Regarding counterparties, we have 3 (those are listed above in that thread), so that lower and diversify, but does not eliminate, our counterparties risk. We still don't know how we would rank in the "food chain" with these collaterals if a given counterparty liquidate or goes bankrupt.

 

- Regarding liquidity risk if a counterparty exit the contract, people here think that these should be very liquid. Someone said that there is normally an ending date for the counterparty so it can't exit the contract at will. Basically, we can exist these contracts at will, but it might imply an additional cost.

 

So, even if everything is still not 100% clear (these hedges are indeed not simple to understand), that's how I see it. It's an ark above the ground in case we would have a flood in the stock market. That's not a perfect ark since we have some counterparties, but it's overall a fairly solid ark. But's it's also a double hedged sword. If it does not rains and the sun shines significantly, that ark could burn and kill us too and that's NOT an insignificant risk. Even if we're not killed, it could hurt us very significantly.

 

Any more information and/or comment by the boarmembers are welcome and think that some further details and information publicaly provided by Fairfax to all shareholders would be helpful to them.

 

Cheers!

 

 

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Basically, that means that if the given indexes double and everything else remains the same, we could theorically get back to zero (see next post).

 

No, I think I got that wrong. We would lose approximately 50% of our equity (a cost of 4,8 billions). The indexes would need to triple in order to get back to zero.

 

Also, a further comment. The Russell 2000 is specificaly an especially imperfect hedge. This is a small caps index.

 

http://www.russell.com/indexes/data/fact_sheets/us/russell_2000_index.asp

 

As far as I know, our equities portfolio is mostly not a small caps one. If that information is correct, this 3,3 billions $ Russell 2000 equity swap (short position) looks more like a bet on the future value of small caps than a plain vanilla hedge on our equities investment portfolio.

 

 

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My understanding of the whole hedge was that for FFH it had a cap of ~200million for the downside (inflation happens) and unlimited upside (deflation happens). Is that understanding wrong? I believe FFH must have thought thru the risks either way...

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My understanding of the whole hedge was that for FFH it had a cap of ~200million for the downside (inflation happens) and unlimited upside (deflation happens). Is that understanding wrong? I believe FFH must have thought thru the risks either way...

 

No. This is a specific hedge (called CPI-linked derivative contracts) in the whole Fairfax hedges instruments. You can take a look at page 12 of their last quarterly report to take a look at the basic numbers behind the hedges fhat Fairfax has:

 

http://www.fairfax.ca/Assets/Downloads/2010Q3.pdf

 

Cheers!

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Max exposure for FFH is the amount spent.

 

Nick is correct.

 

If however, you aren't looking at risk related to original cost, and you are looking at what effect this could have on book value, then you need to understand that these contracts have been marketd up already, so now they can be marked down (from Q3 '10 values) much more than $200m... so it depends on what you are looking at.

 

From a book value perspective, Fairfax's cost is irrelevant, but it is important to understand their mindset and invesetment philosophy.

 

My 2 cents,

 

Ben

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My understanding is that this derivative contract is equivalent of buying put(except with posting collateral if the hedges moves against). if the index is higher than stated in the end of the contract(about 10 years), FFH will lose the premium it paid(~170M).. If there are any fluctuations in the index between now & end of the contract they have to mark down their asset numbers(accounting & not cash). Please correct me if i'm wrong, thanks!

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My understanding of the whole hedge was that for FFH it had a cap of ~200million for the downside (inflation happens) and unlimited upside (deflation happens). Is that understanding wrong? I believe FFH must have thought thru the risks either way...

 

No. This is a specific hedge (called CPI-linked derivative contracts) in the whole Fairfax hedges instruments. You can take a look at page 12 of their last quarterly report to take a look at the basic numbers behind the hedges fhat Fairfax has:

 

http://www.fairfax.ca/Assets/Downloads/2010Q3.pdf

 

Cheers!

 

The deflation hedge is structured like an option and FFH's risk is limited only to the original premium paid. This is clear from their quarterly report.

 

As for the equity swaps, you have raised two concerns: Counterparty risk, and the mismatched nature of the equity hedge.

 

Given FFH's cautiousness about the economic situation, it is reasonable to assume that they have taken similar steps to minimise counterparty risk as they did when they had the CDS exposure. It is also important to keep in mind that daily posting of collateral will limit credit exposure to just a few days of market movement. Imo, this is not a huge risk.

 

As for the risk that the S&P or the Russell doubles or triples while FFH's equity portfolio stays stagnant, how likely is this scenario? For this to happen, either corporate earnings have to double/triple or PERs have to go up to tech bubble levels (50-60x?) while at the same time FFH's equities did not move in sympathy with the broader market. I think it is way more likely we have major terrorist event plus a major natural disaster in one year than for this scenario to play out.

 

 

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For this to happen, either corporate earnings have to double/triple or PERs have to go up to tech bubble levels (50-60x?) while at the same time FFH's equities did not move in sympathy with the broader market. I think it is way more likely we have major terrorist event plus a major natural disaster in one year than for this scenario to play out.

 

 

oec, that's a good point and this catastrophic scenario is probably not very likely (a 1 to 50 or 1 to 100 years event?), but frankly I'm better at looking at overall ark constructions than to predict rain and sunshine.

 

But, like I said before, it would be best if we would have more informations on all these hedge instruments to get a deeper understanding of them. It would help us to better assess the risk/rewards of them and, even more when you have an important part of your net worth in that business, this is essential in my opinion.

 

Cheers!

 

 

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  • 4 years later...

In case anyone's interested.

 

From page 20, 2014AR...  (More discussion on page 59)

 

 

 

"These losses are significant but they are mostly unrealized, and we expect both of them to reverse when the ‘‘grand disconnect’’ disappears – perhaps sooner than you think! In a declining market, like 2008 – 2009, we expect our common stock portfolio to come down much less than the indices, thus reversing most of the net losses resulting from our hedges. As I said last year, we are focused on protecting our company on the downside against permanent capital loss from the many potential unintended consequences that abound in the world economy. In our 2008 Annual Report, we showed you the table below, that quantified our unrealized losses in the 2003 – 2006 period and their reversal in 2007 and 2008:..."

 

http://www.fairfax.ca/files/doc_financials/Final-2014-Annual-Report-for-website_v002_q64b02.pdf

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It looks like Fairfax is once again going to reap the benefits of the huge equity hedges....this time it was certainly a long time coming! We have been here before and it certainly feels good to be a Fairfax shareholder during these times...

 

Dazel

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It looks like Fairfax is once again going to reap the benefits of the huge equity hedges....this time it was certainly a long time coming! We have been here before and it certainly feels good to be a Fairfax shareholder during these times...

 

Dazel

 

How exactly are they "reaping the benefits"? The have incurred major losses on them and at the same time sold of "cheap long term holdings" and raised capital to pay for those hedges and other crap like BBRY. I think I made a silly post (probably the only kind I make) in 2012-2013 asking whether people in 2015-2016 would finally view the Fairfax bets (don't call them hedges at this point sorry) as mistakes. I guess I don't have a long enough time frame.

 

I can't count the times anymore that people post these comments after a mere 4% market drop. Can't we just wait and see whether we actually go down 40%+? With a lot of cash on hand I would definitely like to believe someone could time down markets but I don't believe there is a way for anyone to know.

 

In any case, if Fairfax does finally reap the benefits of the equity hedges (meaning another '08 like crash otherwise it was all for nothing), we might all have bigger problems than a battered portfolio.

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Tombgrt,

 

I don 't care what Fairfax was doing in the past (although they have made me a lot of money!)...what matters to me is where they are today and headed in the future.

 

We have had a crash! people are just not talking about it...commodities have dropped 60% at least across the board, emerging markets have crashed (china is the latest), currencies have crashed and we have 2.75% 30 year treasury.

 

Your frustration is noted and you are not alone...Fairfax is not a well liked stock at the moment for the reasons you give and I have been critical of the huge hedge losses of the past. However, the Fairfax thesis is playing out and "today" and for the foreseeable future they are positioned the best of anyone i can see in the market place.

 

If you think we are going to once again rally here than Fairfax will once again look silly for the huge hedges...

 

I however, do not....and I have put my money behind it.

 

Dazel

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I care what they did in the past as it can be an indicator of future actions. I can't just look at the good (track record over long term) and ignore the bad and the ugly. We will see.

 

You are right that we have had a crash in parts. Even in equities many stocks are already correcting. It seems like only a handful of expensive stocks are "keeping up appearances" while we still trade at market all time highs. It will be interesting to see whether everything gets infected. As a side note, isn't it very rare to not have any crashes over the span of a few years? There is always something ugly going on.

 

In any case, I hope you are right Dazel. My watchlist is too long and my list of holdings is too short!

 

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Of course I do care about how they have operated in the past...but I can't eat that performance. and if I am splitting hairs over bbry etc which are recent I must also add the Ridley and Bank of Ireland triples that were cashed out last quarter and went unmentioned!

 

as for crash's-corrections...you are correct that it is extremely odd to not have one every couple of years...the fact that we are now well over 900 days (third longest ever!) without a 10% correction in the U.S makes it obvious that are not only due for this but it is "not" normal to go without it. I agree that the majority of stocks have already corrected and some cases crashed (Chesapeake etc).

 

the junk bond market spreads are showing that the bond market is in correction most global indices have corrected...there is nothing wrong with a good old fashioned correction in the U.S. except one thing.

 

the Fed is out of bullets...they can't create inflation without another QE program and they will not get the political will to do it without a "serious" correction and like you say with out the Fab 5 holding up the market the headlines would read differently...Disney for example is down 20% in two weeks!

 

With that in mind i think the individual equity hedges at Fairfax have made a lot more money this quarter than investors

realize...as they are looking at the russell index hedge...and the deflation hedges...

 

as for your wish to add quality to your portfolio...Fairfax will have close to $10 billion cash to invest into a correction ($6.5b cash plus hedge gains and bond gains).

 

the question on waiting to see if we have a correction or not to buy Fairfax is a good one...and not easily answered. It is my past experience that Fairfax moves up quickly when the market interprets their portfolio appreciation.

 

best of luck!

 

Dazel

 

 

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Good points Dazel, thank you for your comments.

 

Stocks like Disney were up 50% in a year after quadrupling. It's still up YTD! They were hardly cheap on any metric and could easily lose much more. But  I guess it's one of those "relentless compounders at any price" as we discussed a few weeks ago. These kind of stocks could see a 1987 like crash in a matter of days and people would act all surprised. ;) I'm by no means saying they will or that they are severly overvalued but cheap and safe is something entirely different...

 

I'll be rooting alongside you and Fairfax, this market is way too boring!

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On the whole issue of "surprise". I've noted in other posts (somewhere on other sites likely) that the retail investor thinking these days seems to have shifted towards thinking that the market(s) has to reach bubble proportions before a significant downturn can occur. As if the latter can't occur without the former occurring first as a pre-condition.  This style of thinking just seems to limit the possible market outcomes, if not become self-reinforcing and driving markets ever higher. (I worry that it's been a re-emergence of a late 1920s thinking with the benefit of hindsight - that once a pattern seems confirmed - people will REALLY pile in / pile out.)

 

In the 70s, 80s and 90s I just don't recall much investor thinking along those terms for markets in general.  (it was there for sectors like oil, gold, bonds...)  Maybe because people thought that the possibility of a 1929 style collapse had been banished from the markets, or a legacy of the 60s-70s more frequent cycling between growth and recession, or a legacy of the 70s various inflations. 

 

Today though, people seem to expect prices will, or MUST, climb to some outlandish, extreme valuations before a retraction can occur, and if it occurs, it must then "crash".

 

Bottom line - it seems investor expectations of the range of possible outcomes has narrowed. That's never good as surprise can lead to knee-jerk behaviour and this self-reinforcing spiral.

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